The month of November was great for the shares of smaller U.S. companies after the election of Donald Trump. The Russell 2000 index increased for 15 consecutive days at one point. It also increased by almost +11% for the month. Trump’s proposed policies around tax cuts and infrastructure spending are expected to be favorable. It is also his promises to ease regulations that are expected to be particularly positive for smaller companies. Regulations I am referring to revolve around healthcare (i.e. Affordable Care Act), labor (i.e. overtime rules), and minimum wages (i.e. pressure to increase them).
Trump’s proposed policies would be beneficial to smaller companies, if he can make them happen. Nevertheless, I am not so sure the +11% increase of the Russell 2000 in November made a whole lot of sense. Valuations of Russell 2000 companies were already exorbitant. Investors need to be careful what price they are paying for these smaller companies. According to one long-term investor:
The price you pay determines your rate of return. – Warren Buffett
What is EBITDA?
Given many small companies are yet to generate positive earnings, it would be futile to value (e.g. price-to-earnings) them on traditional metrics of profit. Alternatives would necessary. Instead of basing a valuation on earnings, a commonly used alternative is something called earnings before interest, taxes, depreciation and amortization (“EBITDA”). The use of EBITDA can be divisive given the many items it excludes from earnings. Nevertheless, EBITDA is useful when evaluating smaller companies that may yet to be profitable. According to an accounting professor:
[EBITDA is] a quick and dirty way to assess the firm’s ability to pay back interest or debts. – Gil Sadka, Assistant Professor of Accounting, Columbia Business School
Earnings flow to shareholders, which is why they compare they compare earnings against price of their shares when coming up with a valuation (e.g. price-to-earnings). EBITDA though flows to both shareholders and creditors (e.g. bondholders), as Professor Sadka indicated. When using EBITDA in a valuation, the appropriate numerator needs to consider the price or market value of common shares and debt. This is referred to as Total Enterprise Value (“TEV”).
Illustrated in the 21-year graph below is the aggregate TEV-to-EBITDA of the smaller U.S. companies listed on the Russell 2000 index. Before 2013, these companies typically were valued in a fairly tight range of 9-times EBITDA to 12-times EBITDA. That all changed after 2012 in the age of the Unicorn Club. Investors have since bid up tech start-ups to valuations of more than $1 billion.
By the end of 2015, the average company on the Russell 2000 was valued at 21.0-times EBITDA. This was extremely high. In fact, this valuation exceeds two (2) standard deviations (red dotted line) looking back 21 years. More recent data from last week indicated the average valuation was 20.6-times EBITDA, which is still exorbitant.
Profitability Doesn’t Matter
You would think a sky-high valuation would be backed by improving fundamentals, but that is not the case. The operating margin of the average Russell 2000 company in the late-1990s approached 9%. You can see from the graph below that trend has been downwards ever since. The average operating margin in 2015 was only 3.4%. This was the second lowest operating margin in 21 years. More recent data from last week indicated the average operating margin was 4.4%, which was still below the 21-year trend line (red dotted line).
Return on equity (“ROE”) has also been very weak. It was respectable back in the mid-1990s when the average Russell 2000 company had an ROE of +8% but times have changed. As shown in the graph below, the average ROE has since trended downwards. In 2015, the average ROE was 0%. More recent data from last week indicated the average ROE was +1.1%, which is also below the 21-year trend line (red dotted line).
Extreme Financial Risk
Given the weak profitability, you would think smaller, less established companies would be prudent with financial leverage. As illustrated in the graph below, net-funded-debt-to-EBITDA (“NFD-to-EBITDA”) has historically been around 3-times but that changed in 2014. NFD-to-EBITDA exceeded 4-times that year. It further increased the year following to 6.1-times. Just like the valuation example, this new found degree of financial leverage has exceeded two (2) standard deviations looking back 21 years. More recent data from last week indicates the average NFD-to-EBITDA still exceeded two (2) standard deviations given it was at 5.4-times. What is particularly troubling about this is there has been rising delinquencies amongst small company borrowers.
Smaller U.S. companies as represented by the ones listed on the Russell 2000 now have valuations that are more than two (2) standard deviations greater than their 21-year average. These same companies are also, on average, less profitable than they were before. What makes their valuations even more perplexing is financial leverage looks to be the highest in a generation. If the price paid indeed determines the rate of return, then investors in small U.S. companies should ignore what happened in November and consider revising down their long-term return expectations.
Whether or not you believe valuation drives futures returns, please consult an investment fiduciary before making any investment decisions.