Source: Janus Henderson Investors, Wilshire Atlas. Russell 2000 Growth Index, data as at 30 June 2019.
Enthusiasm for innovation within the software and biotech industries has driven considerable momentum around all stocks tied to these themes, creating excessive valuations. There is no way to assign an earnings multiple to a biotech or software business that is yet to turn a profit, but revenue multiples have expanded considerably.
We do not try to predict when, but we believe a day of reckoning is due for many of the highly valued, money-losing companies in the index. During broad market sell-offs, it is often the highly valued, momentum-driven stocks that fall hardest as investors recalibrate what type of revenue multiple they are willing to accept for a business.
Economic slowdowns also pose risk for these stocks. Unprofitable companies often sustain their businesses through multiple capital raises. That is easier to do when the economy is strong, but capital often dries up as it slows down.
We believe the market has taken an undiscerning view toward companies with even a whiff of cyclicality tied to their business. For example, there are many stocks that trade at single-digit multiples, having sold off in recent quarters because of exposure to cyclical end markets or exposure to slower-growing sectors.
In many cases, the market fails to give these companies credit for their aftermarket businesses, which can create a steady, recurring revenue stream that makes earnings growth more durable. In addition, we feel that current valuations may be pricing in a recession for many of these companies. Furthermore, while many of these companies could experience slow or even negative revenue growth, many generate strong free cash flows that they can deploy to buffer the potential impact to earnings.
We also see opportunity among small-cap stocks tied to innovative trends such as biotech and software as a service but believe high valuations within those industries require a selective approach. For example, biotech companies with US Food & Drug Administration (FDA) approved or late-stage pipeline products as well as diversified portfolios as opposed to companies that possess only single-product and/or early-stage drug candidates.
In addition, investors may gain exposure to biotechnology by holding companies providing services that improve drug delivery and development. Such businesses may still benefit from broad industry innovation and the proliferation of new drugs but should be less risky than owning a stock whose performance is tied largely to the binary outcome of a single clinical trial.
In short, we believe the Russell 2000 Growth Index still has opportunities within it – but in our view, investing in a passively managed, index-based product with a large portion of highly valued, unprofitable companies looks risky.