Insights From ETFs: Getting exposure to the “mispriced” segment of the market
The small and mid-cap segments of the markets are common places for many legendary investors who started out in their early professional careers, such as Peter Lynch, Warren Buffet, Sir John Templeton, etc.
There are a few reasons why this is the case. First, this market segment not only includes high-quality companies with a long runway for growth but, at the same time, is ignored by the majority of investors, as these names are not usually well-known and well-covered by analysts. As a result, this playground is usually less crowded, allowing investors who are willing to do their homework to earn above-average returns.
Second, great companies started out as small companies. Amazing performers such as Walmart, Berkshire, Amazon, Microsoft, etc., all graduated from the small-cap segment to the large-cap when their businesses became more established and their growth matured.
Due to better prospective returns, as a group, historically small/mid-cap segments of the market have consistently traded at a premium to large-cap names for many years. The rationale behind the premium is that small companies are mostly in the early stages. Therefore, investors reward these segments of the market with a higher multiple due to their expected longevity in growth assumptions.
However, the trend started to reverse in early 2021, when valuations of small/mid-cap gradually went down compared to large-cap names, and this trend continues to be the case now. This spread between small/mid-cap relative to large-cap names has been the widest in years.
For example, the Nasdaq, which is heavily dominated by Big Tech names, was up around 31% this year. In addition, the S&P 500, which was down around -19% in 2022, already has recovered 15% so far in 2023. This great performance of the U.S. indices was largely contributed by the “Magnificent Seven” (Apple, Microsoft, Meta, Nvidia, Tesla, Alphabet (formerly Facebook) and Amazon), as those companies are at the forefront of the Artificial Intelligence trend (AI). These companies have lifted the overall market due to their size. When investors exclude these seven names, the result of the S&P 500 was actually flat or slightly up.
On the other hand, the Russel 2000 Index, the proxy for the small-cap segment, was up approximately 7.3% this year, while this index was down -35% in 2022. On an absolute basis, this period also marks the very first time small/mid-cap companies have traded at below 15X multiples since the Great Financial Crisis of 2008.
We think the discrepancy between the two segments does not make sense and is unlikely to be sustainable for a long time for a few reasons. First, with interest rates largely peaked (or nearly), risky assets such as small-cap names tend to have a stronger recovery relative to large-cap segments, mostly perceived to include safer, more stable companies.
Second, due to the attractive risk-free yields in the current interest rates environment, which is approximately five per cent, there is money still sitting on the sideline, waiting to return when the uncertainty is gone. Generally, large-cap names usually experienced more inflows at the beginning of the economic recovery due to their liquidity and popularity. After that, we think small-cap is poised to outperform when the next bull market begins.
Having said that, not all names in the small and mid-cap segments are attractive investments. For example, some companies shrink their business over time from a much larger company to a small-cap name as the business faces a secular decline. Therefore, we think this is the market for stock pickers. On the other hand, we think investors can take advantage of this huge discrepancy by owning a basket of names through a diversified portfolio.
Below are three ETFs that we like:
SPDE S&P Mid-Cap 400 ETF Trust (MDY)
The SPDR S&P Mid-Cap 400 ETF Trust (MDY) consists of U.S. mid-cap companies across multiple sectors and industries and follows a long-term, buy-and-hold approach.
MDY has $20.0 billion in assets under management (AUM), with a twelve-month trailing yield of 1.30% and a Management Expense Ratio (MER) of 0.23%.
MDYís portfolio is broadly diversified, with the maximum position sizing for each name only 0.8% of the total portfolio. The top five holdings consist of Builders FirstSource Inc., a manufacturer and supplier of building materials and construction services to homebuilders, Hubbell Incorporated, a designer and manufacturer of electrical and utility solutions, Reliance Steel & Aluminum Co., a diversified metal solutions provider and metal processing services to general manufacturing and construction, Jabil Inc., the company offers electronics design and production, as well as product management and electronic circuit design services, Graco Inc., a manufacturer of systems and equipment used to move, control, and spray fluid and powder materials.
The ETF mainly focuses on three main sectors, including Industrials at 23.0%, Consumer Discretionary at 15.0%, and Financials at 13.5%.
Vanguard Small-Cap Growth ETF (VBK)
The Vanguard Small-Cap Growth ETF (VBK) includes small-cap companies in the U.S. that are in their early growth stage. The fund tracks the performance of the CRSP U.S. Small-Cap Growth Index. VBK currently has $30.5 billion in AUM, an MER of 0.07% and a twelve-month trailing yield of 0.68%.
The portfolio is broadly diversified. The top five holdings account for around five per cent of the portfolio, including Fair Isaac Corporation (FICO), a software solution provider that provides individual credit scores, supports advanced analytics capabilities for financial institutions to evaluate consumers’ credit, Entegris, Inc. (ENTG)., Targa Resources Corp (TRGP)., Exact Sciences Corporation (EXAS), PTC Inc. (PTC), a cloud software provider that enables digital transformation for businesses.
VBK is heavily concentrated in high-quality sectors, with 22.7% allocated to Information Technology and 19.6% allocated to Healthcare.
iShares Russel 2000 Growth ETF (IWO)
Finally, iShares Russel 200 Growth ETF (IWO), which tracks the performance of the Russel 2000, focuses on the U.S. small-capitalization growth companies, with the flexibility to invest up to 20% of the total portfolio into futures, options, swap contracts or cash.
The ETF has had a 10-year annualized return of 8.9%. IWO has amassed a total AUM of around $10.1 billion, with an MER fee of 0.23%.
The top five holdings are Super Micro Computer, Inc., one of the biggest winners in the small-cap sector this year due to the AI trend, SPS Commerce, Inc., a cloud-based supply chain management solution provider, ChampionX Corporation, which provides chemistry solutions and engineered equipment to the oil and gas companies, Rambus Inc., which provides semiconductor products globally, Novanta Inc., a provider of photonics, vision and precision motion in the US.
*This article was part of our ETF Update Letter that we wrote three months ago. Sign up for ETF Update here to receive more articles like this on a monthly basis.
Disclosure: Authors, directors, partners and/or officers of 5i Research have a financial or other interest in XIT and ZRE.