A cheap index can stay cheap when much of it does not make money

Small caps look cheap against large caps on most standard measures. The comparison hides something important: a large share of the small cap index does not make money, and that part of it has no earnings for a cheap valuation to recover to.

Cheap for a reason

A valuation discount is only an opportunity if earnings are there to be revalued. Profitable small companies can re-rate when conditions improve. Unprofitable ones depend on raising capital, and their shares tend to fall when capital gets expensive, whatever the index-level valuation says.

An index-wide view averages the two together and makes the whole look more attractive than either part.

What I'm watching

• The share of index members with positive earnings
• How the profitable members perform against the rest
• Equity and debt issuance by smaller companies

Where I stand

Short, on an index whose cheapness is partly an illusion of averaging. The profitable part is interesting; the index as a whole is not.

What would change my mind

Profitable companies taking a larger share of the index through strong earnings. That would make the headline valuation mean what it appears to.