Small-cap stocks were leveraged by unprofitable companies. Can they keep climbing?

Foaming in US stock markets can be seen in small caps as well.

The Russell 2000 has outperformed the S&P 500 since its April lows this year, hitting records this week thanks to bets that interest rate cuts can keep it rising. These hopes have fueled optimism that small companies — generally, those with a market capitalization between $250 million and $2 billion — will continue to rise.

But under the hood of the index, some investors see reasons for concern. Unprofitable companies in the Russell 2000 are up about 19% this year through Oct. 21, more than double the 9% gain of profitable companies, according to Oren Sheeran, portfolio manager at the Lazard US Systematic Small Cap Equity ETF (SYZ). The S&P 600 — the small-cap index that requires positive earnings — was up about 2% for the year as of Thursday’s close, below rates offered by lower-risk CDs.

Sheeran said in an interview with Investopedia that investor enthusiasm about the prospect of lower interest rates, which tends to benefit small companies, may be driving the rise in speculation. (Federal Reserve Chair Jerome Powell tempered interest rate cut expectations this week after the Fed cut its key interest rate for the second time in as many months, but market participants still expect further cuts.)

Despite the rise in speculation, fund managers continue to defend small stocks, because they are expected to show stronger earnings growth after two years of relatively weak earnings movement.

Small-cap valuations also remained relatively attractive at the end of the third quarter even after rising from April lows. This shows up in two ways – The total market capitalization of the Russell 2000 as a percentage of the total Russell 3000 market index is 4.4%, which is well below the historical average of 7.6% since late 1984, according to Royce Investment Partners. Valuations of small-cap compared to large-cap companies as measured by enterprise value to earnings before interest and tax, after excluding companies with earnings losses, are near 25-year lows, the company said. Meanwhile, the Russell 2000’s estimated 2025 earnings are expected to rise more than 25%, more than double the Russell 1000’s 10% gain.

The generally strong US economy is seen as particularly beneficial for small businesses, which tend to have less international business. There is uncertainty as “recent jobs numbers have been disappointing, consumer confidence remains wavering and manufacturing data is sluggish,” Francis Gannon, Royce’s co-chief investment officer, wrote in a quarterly note earlier this month. “However, consumers continue to spend, the economy is growing, and access to capital has expanded as interest rates decline.”

Concerns about small companies mirror those that have reached stocks generally, with indexes rising to record highs, but unlike their larger counterparts, they have not had their time in the spotlight for years. If asset prices and historical returns return to their long-term averages, according to mean reversion theory, penny stocks should continue to perform.