Among the various investment factors, size is arguably the easiest to comprehend. Put simply, the size factor is rooted in the notion that smaller stocks can outperform large-caps, though small-caps are, broadly speaking, more volatile.
The Fama-French Three-Factor Model designed by Nobel Laureate Eugene Fama and famed researcher Kenneth French states “small company stocks (small cap) tend to act very differently than large company stocks (large cap). In the long run, small-cap stocks have generated higher returns than large-cap stocks; however, the extra return is not free since they have higher risk.”1
Through the first half of 2018, small-caps are receiving renewed attention due in large part to their out-performance over large-cap equivalents. Year-to-date, as of July 13, 2018, the Russell 2000 Index and the S&P SmallCap 600 Index are up an average of 11.45% compared to 4.77% for the S&P 500 Index.2
The healthcare sector is one of the primary drivers of this year’s small-cap resurgence. Importantly, there are multiple reasons why smaller healthcare companies are impressing this year.
Examining Small-Cap Healthcare Catalysts
“Small health care companies are outperforming large caps in health care from increased expectations for acquisition of smaller companies, stronger innovation from smaller companies and that smaller companies may be more immune to concerns about regulatory pressures in healthcare,” said S&P Dow Jones Indices.3
Another factor in favor of the broader small-cap complex, including the healthcare sector, is that smaller stocks are often more dependent on the U.S. for large portions of their revenue than are large companies. By generating more revenue on a domestic basis, smaller companies are less vulnerable to a stronger dollar than large, multi-nationals the do businesses in scores of ex-US markets. As the chart below indicates, small-cap healthcare companies generate a significant portion of sales in the U.S.
On a note related to the strong dollar, the Federal Reserve has boosted interest rates twice this year and two more rate hikes could be delivered before the end of 2018. Higher financing costs can be burdensome to some smaller companies that are reliant on capital markets, underscoring the point that investors should evaluate smaller healthcare companies with enough cash to survive at current burn rates.
An Important Trait
In the world of healthcare index and exchange traded funds (ETFs), there are important industry-level differences between large- and small-cap products. Over the past several years, the large-cap S&P 500 Health Care sector has seen its weights to biotechnology, life sciences and pharmaceuticals decline while its exposure to healthcare equipment and services firms has increased.
Conversely, the S&P SmallCap 600 health care sector has witnessed rising exposure to biotechnology, life sciences and pharmaceuticals companies.4
This is an important sector attribution at a time when smaller biotechnology and pharmaceuticals companies are playing significant roles in small-cap healthcare’s leadership.
Small Cap Health Care Names Have Seen Outperformance Over Their Large Cap Counterparts
A Basket Approach To Smaller Healthcare Names
1 Source: Portfolio Solutions https://portfoliosolutions.com/latest-learnings/fama-french-three-factor-model
2 Source: Bloomberg, L.P., as of July 13, 2018
3 Source: S&P Dow Jones Indices July 2, 2018 http://www.indexologyblog.com/2018/07/02/small-cap…
4 Source S&P Dow Jones Indices March 28, 2018 http://www.indexologyblog.com/2018/03/28/whats-in-…
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This fund may not be suitable for all investors. There are risks involved with investing in ETFs including the loss of money. The Fund is considered non-diversified and as a result may experience great volatility than a diversified fund. The Fund’s investments are concentrated in the pharmaceuticals and biotechnology industries, and underperformance in these areas will result in underperformance in the Fund. Investments in small and micro capitalization companies are more volatile than companies with larger market capitalizations.
Companies in the pharmaceuticals and biotechnology industry may be subject to extensive litigation based on product liability and similar claims. Legislation introduced or considered by certain governments on such industries or on the healthcare sector cannot be predicted.
Companies in the pharmaceuticals industry are subject to competitive forces that may make it difficult to raise prices and, in fact, may result in price discounting. The profitability of some companies in the pharmaceuticals industry may be dependent on a relatively limited number of products. In addition, their products can become obsolete due to industry innovation, changes in technologies or other market developments. Many new products in the pharmaceuticals industry are subject to government approvals, regulation and reimbursement rates. The process of obtaining government approvals may be long and costly. Many companies in the pharmaceuticals industry are heavily dependent on patents and intellectual property rights. The loss or impairment of these rights may adversely affect the profitability of these companies.
The development of new drugs generally has a high failure rate, and such failures may negatively impact the stock price of the company developing the failed drug. Biotechnology companies may have persistent losses during a new product’s transition from development to production. In order to fund operations, biotechnology companies may require financing from the capital markets, which may not always be available on satisfactory terms or at all.
Cash burn: Burn rate is normally used to describe the rate at which a new company is spending its venture capital to finance overhead before generating positive cash flow from operations; it is a measure of negative cash flow. Burn rate is usually quoted in terms of cash spent per month.
Poliwogg Medical Breakthroughs Index – The Poliwogg Medical Breakthroughs Index is designed to capture research and development opportunities in the pharmaceutical industry. PMBI consists of small and mid-cap pharmaceutical and biotechnology stocks listed on US exchanges.
The S&P 500® is an index of 500 stocks chosen for market size, liquidity and industry grouping among other factors. S&P 500: an index of 500 stocks chosen for market size, liquidity and industry grouping among other factors.
The Russell 2000 index is an index measuring the performance of approximately 2,000 small-cap companies in the Russell 3000 Index, which is made up of 3,000 of the biggest U.S. stocks.
The S&P 600 is an index of small-cap stocks that meet specific liquidity and stability requirements. This is determined by specific metrics such as public float, market capitalization, and financial viability among a few other factors. Market capitalization, for instance, must fall between $450 million and $2.1 billion to ensure individual assets do not overlap with the larger S&P 500 or mid-cap S&P 400 indexes.
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