Mailbag: Steering Clear of Small Caps, Finding Cannabis Stocks

Editor’s Note: Welcome to the Early Investing Mailbag. Each week, we answer questions we think will help you learn about investing in pre-IPO startups and cryptocurrencies. If you have any questions for us, please email us at mailbag@earlyinvesting.com. Just remember, we can only answer your general questions for information and strategy. We can’t offer personal advice.

Q: A few months ago, Adam wrote that he thinks the Russell 2000 small cap index is overvalued. It has fallen significantly since then, and I am wondering if now’s the time to move into U.S. small caps. – Phil K.

A: In an article I wrote back in early October, I highlighted the fact that the Russell 2000 is far more expensive than it looks. While the advertised price-to-earnings (P/E) ratio of the Russell 2000 was 19 back then, the real P/E ratio was 59. That’s a bubbly valuation.

Even with the recent market pullback, the leading U.S. small cap index still looks quite bubbly. The Russell 2000’s trailing P/E ratio (of the last 12 months) remains elevated at 40. That means that at current earnings, you’d have to wait 40 years for the companies to earn as much as you paid for them.

I don’t think anyone should be buying such an expensive stock index, especially in this market. The trade wars appear to be heating up. The Fed just hiked rates again. And nobody knows for sure what it’ll do next.

The Fed has kept interest rates artificially low for almost 10 years now, and the results of this experiment have yet to play out.

I believe many companies are addicted to these low rates and won’t survive without them. That includes much of the Russell 2000.

David Bianco, America’s chief investment officer at Deutsche Asset Management, doesn’t think much of the credit worthiness of Russell 2000 companies either. “Eighty-four percent of the Russell 2000 with a credit rating is junk-rated,” Bianco says.

These debt-laden zombie companies are already beginning to show signs of stress despite the fact that interest rates are still incredibly low by historical standards. What happens if the Fed actually keeps hiking? It won’t be pretty.

Personally, I’d much rather put money to work in private U.S. startups than small cap stocks. Quality startup companies are outgrowing and disrupting corporate dinosaurs as they struggle to adjust to technology trends and tighter credit conditions.

My advice: Continue to steer clear of U.S. small cap indexes.

+ Early Investing Co-Founder Adam Sharp

Q: I am having trouble finding firms that allow the purchase of marijuana stocks. Any thoughts? – Richard W.

A: I assume you’re referring to your brokerage firm. If it’s looking at just the major U.S. stock exchanges, that’s a problem. Marijuana stocks aren’t legal at the federal level, so American companies can’t list on them. A handful of big Canadian marijuana companies, like Canopy Growth and Cronos, have successfully listed on American exchanges, so you can invest in them. But other than these Canadian giants, it’s slim pickings in the U.S.

Instruct your brokerage to look at marijuana companies listed on the Canadian exchanges. The Canadian Securities Exchange has more than 100 marijuana stocks listed, including big American companies like Cresco, MedMen and Green Thumb.

There are also a few interesting American marijuana companies trading on the over-the-counter (OTC) markets. And next year, I expect more will go this route, giving you a range of choices among many quality companies. Some brokers will ask you to sign an (online) agreement before letting you buy OTC stocks through them.

+ Early Investing Co-Founder Andy Gordon