Russell 2000: Is the Small-Cap Index in a Rut?

The Russell 2000 Index (^RUT) is feeling a bit sluggish these days.  Who can blame it?  After capping off 2014 with a 9.7% gain in the fourth quarter, the index rose another 4.3% in the first quarter of 2015.  With the onset of spring showers, the Russell wilted 2.5% in April and so far in May is up 2.0% month to date.

The Russell 2000 is an index created to capture the performance of 2,000 small cap companies.  Although the average market cap in the index is $2 billion, that number is skewed by several stocks with market caps ranging from $5 billion to $11 billion.  The more representative number is the median market cap which equals $700 million.  The median is the number at the midpoint of all the data and highlights the most common market cap for stocks in the index.  That said, the Russell is weighted by market cap, meaning that the largest cap stocks represent a bigger piece of the index and exert more influence over the index’s performance.

Small cap stocks have generally underperformed large cap stocks for the past three years.  However, last fall small caps perked up and began outperforming.  Part of this was due to portfolio managers trying to avoid earnings issues due to the stronger dollar. Small cap companies typically collect all of their revenue in U.S. dollars and are impervious to fluctuations in currencies. Large cap companies on the other hand usually sell quite a bit of goods overseas.  Their revenue is reduced when the overseas currencies fall in relation to the dollar.

Another part of the outperformance is due to the sector weightings within the index. Healthcare is the second largest sector in the Russell 2000 and has been a very robust sector. Although 8 out of the 9 sectors within the Russell were positive in the first quarter, the healthcare sector accounted for almost 40% of the first quarter gain.

In addition, two of the top ten holdings in the Russell 2000 are biotechs.  Biotech stocks have been red hot with the Nasdaq Biotech Index (NBI) up 50% in the past 12 months and up 16% this year.  However the group hit an air pocket in April, dropping 9% in the last 3 days of the month.  Isis Pharmaceuticals (ISIS) and Puma Biotech (PBYI), both top ten holdings in the Russell, dropped 11% and 23% respectively in the month of April.  Overall the healthcare sector represents about 16% of the Russell 2000 and contributed 1.6% of the first quarter gains.  Within the healthcare group biotech was responsible for about half of that performance. 

The Russell will likely regain its momentum.  Healthcare should continue to outperform the market due to increased usage from Obamacare and a favorable reimbursement environment.  Biotechs are by nature extremely volatile but have already recovered 2.5% in May. Investors should also keep their eye on the financial sector, which represents 25% of the Russell 2000, the largest industry group in the index.  The financial sector tends to outperform in periods of rising interest rates and should help propel the Russell 2000 if the Fed keeps its promise to eventually raise rates.

Around the Roadrunner Portfolios

Weyco Group (Nasdaq: WEYS) continues to grow its Bogs boot brand, the all-weather comfort footwear that is key to the company’s turnaround, at solid double digit rates.  In the fourth quarter of 2014, Weyco sold almost 70% more Bogs than the previous year. That blistering pace was due to the brutal winter that swept across most of the U.S. early in the winter season.  

Although first-quarter 2015 growth of Bogs was lower at 20%, increasing demand for the company’s Nunn Bush and Stacy Adams product is percolating and boosting growth.  After growing 5% last year, Stacy Adams’ sales lifted 15% in the first quarter.  Colorful modern driving mocs and slip-ons are appealing to a new set of young urban customers. Department stores are beginning to notice and increase orders.  Nunn Bush, known for its more traditional shiny black shoes, grew sales 5% in the first quarter after declining 4% last year.

Earnings growth continues to accelerate, up 13% for the first quarter versus 10% growth last year.  With sales growth now being generated by several different brands, Weyco has many legs to stand on. Newly introduced Bog’s sandals have enjoyed a warm reception and continued improvements in Nunn Bush and Stacy Adams will help diversify Weyco’s product portfolio.

Gentex (Nasdaq: GNTX) continues to drive earnings as more consumers opt to include its self-dimming mirrors in their cars.  Once considered part of an elite upgrade package, Gentex’s mirrors are finding themselves as an option on mid-priced to lower-priced sedans.  Camry, Subaru and Civic have joined the ranks of swanky BMW models who offer Gentex products.  

Popularity of Homelink, Gentex’s wirelessly controlled garage door opener and Smartbeam, an auto-dimming high beam feature, has added to revenue growth. Gentex grew revenue 10% in the first quarter despite a 2% decline in worldwide light vehicle production. Part of this is via new contracts with automotive equipment manufacturers who agree to include Gentex’s products as an option. Consumers, who have become accustomed to electronic gadgetry in their cars, are increasingly hungry for driver assist technologies.

The company had $665 million of cash in March, $108 million of which was generated in the first quarter. After subtracting debt, Gentex has $1.37 per share in cash, a number that grows each quarter.  Earnings came in 1 penny better than expected and should equal $1.04 this year.

Exactech (Nasdaq: EXAC) released first-quarter financial results that were hindered by foreign currency effects hurting foreign sales growth (i.e., a strong U.S. dollar), but Exactech’s underlying orthopedic joint replacement business is solid. In addition, the second half of the fiscal year looks strong with several new-product introductions. As CEO David Petty said in the conference call:

“Sales organization transition and improvement activities will begin to deliver positive results in the second half of this year. Additionally, for the second half, major product development projects in hip, knee, and shoulder systems remain on track and we plan to be doing surgeries with all three revision systems this year, which will support second-half revenue growth. We’re also pleased with the fundamentally strong condition of the company related to the balance sheet and cash flows.”

In addition, CFO Jody Phillips emphasized that the company “remains solidly profitable.”

Buying a solidly-profitable company with a strong balance sheet and increasing growth prospects that is trading at a temporarily discounted price sounds like a great idea to me.

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