According to a new Ernst & Young, LLP analysis of the Russell 2000 Index’s annual reconstitution, the Index now includes smaller companies than it has in any year since 1993.
Remarkably, the market cap threshold for entry into the 2009 Russell 2000 was just $78 million, down from $167 million in 2008; 562 companies now in the Index had a market cap less than $167 million upon reconstitution. 326 new companies entered the 2009 Index.
Inclusion in an index like the Russell 2000 has many benefits for companies – including broader exposure among more institutional investors and equity analysts, enhanced liquidity and the opportunity to generate capital. However, should a market recovery drive the minimum market cap threshold back up, smaller companies now enjoying these benefits will have to accelerate their growth in order to make it again in 2010.
These and other findings were recently reported in the Ernst & Young LLP, Strategic Growth Markets’ second annual analysis of the Russell 2000 Index reconstitution.
“The lower threshold is truly a sign of the damage inflicted on companies and the overall market through the end of May of 2009,” said Maria Pinelli, Ernst & Young, LLP, Americas Director, Strategic Growth Markets. “It also has created an opportunity for smaller companies to gain enormously valuable exposure before a new, larger investor base. The key now will be to impress investors by delivering sustainable growth, outperforming their peers and creating a growth trajectory that is aligned with or exceeds the overall market trajectory.”
Smaller companies must drive growth through innovation, acquisition
The average market cap of companies included in the 2009 Russell 2000 index dropped 38% to $432M in 2009 from $702M in 2008, while the median market cap decreased 41% to $305M in 2009 from $515M in 2008.
“If the markets continue on their recent return to normalcy, all companies – especially smaller ones – will need to drive their growth through innovation,” said Ms. Pinelli. “However, coming out of the pronounced down market, companies may find it challenging to spend on research and development while focusing on expense reductions as a driver of earnings. Achieving this delicate balance will determine a company’s success or failure – and their ability to sustain the growth it might take to stay in the Russell 2000.”
Ms. Pinelli continued: “While innovation can be organic and home-grown, and is a very attractive attribute a company can demonstrate to the investment community, it can also be acquired or obtained through a joint venture.”
M&A expected to wait, then pop
Ms. Pinelli explained: “Judging from our experience working with high-growth companies, we anticipate a significant increase in mergers and acquisitions activity in both the Russell 2000 and Russell 1000 as companies drive growth through strategic acquisitions.”
Ms. Pinelli said that present M&A activity is being held up due to fewer buyer financing alternatives as well as somewhat unrealistic valuations companies continue to place on assets they are seeking to sell.
“When the financing market returns, it will immediately trigger acquisitions by companies seeking to buy innovation and grab market share – both of which are ideal strategies coming out of a recession,” Ms. Pinelli said. “So not only do we expect to see Russell 2000 companies become more acquisitive, we expect to see far more Russell 2000 companies be acquired due to their strong growth characteristics.”
In 2009, just 63 Index companies were removed from the Russell 2000 upon reconstitution because of an acquisition, compared to 130 Index companies that were acquired and left the Index in 2008.
Healthcare is healthy
The healthcare sector has a strong presence in the Russell 2000. Compared to other industries, healthcare companies had fewer bankruptcies, de-listings and market cap-related deletions from the Index. A greater percentage of healthcare companies were in the Outperformer category than in the Index as a whole, and five out of the top eight companies with the largest market capitalization were in healthcare.
“The success of this sector could be tied to the current political agenda – if more people have access to healthcare, more health products are likely to sell,” said Ms. Pinelli. “Additionally, healthcare companies may be benefiting from an emphasis on efficiency. For instance, the drive towards electronic medical records might encourage new, innovative technological products.”
The energy sector suffered the biggest drop in median market cap in this year’s reconstitution. Energy and telecommunications companies had the most turnover from last year’s Index; industrials had the least.
Top Performers delivered on their promise in spite of market.
The Ernst & Young analysis looked closely at companies that had a higher market capitalization upon reconstitution in 2009 than they had upon reconstitution in 2008. This group, called the Outperformers, included 375 companies.
Compared with other companies in the Index, the Outperformers earned their designation. More specifically, the Outperformers:
• Achieved an average of 13% increase in stock price vs. an average decrease of 38% for the rest of the index;
• Had higher percentage increases in sales between fiscal year end 2007 and 2008;
• Had higher levels of sales growth from the 1st quarter of fiscal year 2008 to the 1st quarter of fiscal year 2009 (up 7% on average) than other stocks in the Russell 2000 in aggregate (down 2.4%);
• Had greater earnings per share in fiscal year 2008 and in the 1st quarter of fiscal year 2009 (average of $0.12 per share) than other stocks in the Russell 2000 in aggregate (average of $0.07 per share);
• Had higher levels of net income in the 1st quarter of fiscal year 2009 (compared to fiscal year 2008);
• As a percentage of sales, had lower levels of debt in aggregate and in most sectors in the first quarter of fiscal year 2009. Conversely, in the financial sector, Outperformers had larger amounts of debt than their counterparts.
“Delivering on your promise in one of the worst markets we’ve faced in our lifetime is quite an accomplishment,” said Ms. Pinelli. “This group of Outperformers was rewarded by investors in spite of the overall market retreat because they were able to sustain their growth, outperform their peers and exceed overall market performance – again, they are models for what other companies will have to do in order to compete as the markets continue to recover.”
About Ernst & Young’s Strategic Growth Markets Practice
Ernst & Young LLP’s Strategic Growth Markets (SGM) practice guides leading high-growth companies. Our multi-disciplinary team of elite professionals provides perspective and advice to help our clients accelerate market leadership. SGM delivers assurance, tax, transactions and advisory services to thousands of companies spanning all industries. Ernst & Young is the undisputed leader in taking companies public, advising key government agencies on the issues impacting high-growth companies and convening the experts who shape the business climate. For more information, please contact Carrie Hall at carrie.hall[.]ey.com or 404-817-5740.
About Ernst & Young
Ernst & Young (ey.com) is a global leader in assurance, tax, transaction and advisory services. Worldwide, our 135,000 people are united by our shared values and an unwavering commitment to quality. We make a difference by helping our people, our clients and our wider communities achieve their potential.
Ernst & Young refers to the global organization of member firms of Ernst & Young Global Limited, each of which is a separate legal entity. This news release has been issued by Ernst & Young LLP, a member firm of Ernst & Young Global Limited located in the US.