Navigating Small-Cap Pitfalls: Why These Russell 2000 Stocks Lack Long-Term Momentum

The Russell 2000, a barometer for small-cap stocks, has long been a double-edged sword for investors. While it offers the potential for outsized gains, its volatility and exposure to underperforming companies make it a minefield for the unwary. Recent data reveals a troubling trend: many Russell 2000 stocks are exhibiting deteriorating fundamentals and weak long-term momentum, even as unprofitable firms temporarily outperform their profitable peers. This divergence, driven by speculative bets on Federal Reserve rate cuts, masks deeper structural challenges that investors must scrutinize.

Deteriorating Fundamentals: A Closer Look

Small-cap stocks with weak financial health are increasingly standing out. Applied Digital (APLD), for instance, has seen its earnings per share plummet by 83.8% annually over the past two years, while its free cash flow margin has collapsed by 54.3 percentage points, signaling a capital-intensive business model struggling to adapt according to financial data. Similarly, Xerox (XRX) has endured a 2.6% annual decline in sales for five consecutive years, with earnings per share falling 15.6% annually-a stark indicator of eroding market relevance according to financial data.

Financial institutions within the index are not immune. Merchants Bancorp (MBIN) faces a net interest margin of just 2.9%, a 13.6 percentage point deterioration in its efficiency ratio over five years, and a tier one capital ratio of 8.9%, all of which raise concerns about its ability to withstand economic stress according to financial data. Meanwhile, Torrid (CURV) has seen same-store sales decline and a 63% annual drop in earnings per share over three years, reflecting broader challenges in retail's shifting landscape according to financial data.

The Paradox of Performance: Why Unprofitable Stocks Outrun Profitable Ones

Despite these red flags, unprofitable Russell 2000 stocks have surged nearly 35–38% since April 2025, outpacing profitable counterparts by a significant margin. This "junk rally" is fueled by investor anticipation of Fed rate cuts, which temporarily buoy weaker balance sheets by reducing borrowing costs and increasing liquidity. Apollo data underscores the shift: as of October 2025, 1,120 Russell 2000 firms reported positive earnings per share (EPS), while 806 reported negative EPS-a stark contrast to historical norms.

However, this trend is precarious. Analysts warn that the rally reflects speculative positioning rather than durable value creation. For example, Bark (BARK) and BrightSpring Health Services (BTSG) face existential risks, with Bark's declining sales and negative free cash flow threatening its operational sustainability, and BTSG's 46% annual EPS drop over four years highlighting chronic inefficiencies. These companies are emblematic of a broader pattern: investors are chasing yield in a low-interest-rate environment, often overlooking fundamentals.

Investor Caution: The Long-Term Risks of Short-Term Gains
While the current environment may justify temporary optimism, the Russell 2000's long-term outlook remains clouded. The index has underperformed the S&P 500 for a decade, with earnings growth narrowing but not closing the gap. For investors, this underscores the importance of distinguishing between cyclical rebounds and structural weaknesses.

Consider the case of Westamerica Bancorporation (WABC), which has seen slower-than-peer net interest income growth and is projected to face an 11% decline in the next 12 months. Such companies exemplify the fragility of small-cap stocks in a tightening credit environment. Similarly, Marzetti Company (MZTI)'s anemic revenue growth-just 4% annually over three years suggests a lack of innovation or market differentiation.

Conclusion: A Call for Discernment

The Russell 2000's recent performance highlights a paradox: unprofitable stocks thrive while fundamentally sound companies lag. Yet, this dynamic is unlikely to persist. As liquidity-driven gains fade and interest rates stabilize, investors must refocus on durable metrics like cash flow, profitability, and capital efficiency. The current rally, while tempting, is a reminder that small-cap investing demands rigorous due diligence. For those willing to screen for deteriorating fundamentals, the Russell 2000 offers cautionary tales-and opportunities to avoid the next wave of underperformers.