Small-Cap ETFs May Get Boost From War

Investors may gravitate away from large caps, which have more international exposure.

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Reviewed by: etf.com Staff
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Edited by: Mark Nacinovich

Small-cap stocks have been an overlooked asset class for some time. That may change for two reasons, one of which wasn’t on many financial advisor and investor radars just two weeks ago. 

Small caps, typically defined as stocks with market capitalizations of between $300 million and $2 billion, have had their proverbial lunch eaten by larger company stocks for at least a decade. 

Over the past 10 years, the SPDR S&P 500 ETF Trust (SPY) has outperformed the iShares Russell 2000 ETF (IWM), the most popular small-cap index ETF, with an annualized return of 11.8% versus 6.2%. And over the past five years, that margin was even larger, at 11.1% annualized for SPY versus only 3.1% for IWM.  

That’s as wide a gap as we’ve seen this century and is reminiscent of the stock market’s trend in early 2000, as the dot-com bubble was starting to burst. This, after many investors have been taught that small caps are expected to produce higher long-term returns, commensurate with their higher risk. The risk has always been there, but the rewards have not.  

Long-Term Trend May Change 

However, two very different types of circumstances point to a potential reversal of that long trend. That makes it something investment advisors should investigate now. 

First, the dominance of large caps over smaller company stocks has led to an unusually large gap in price-earnings and price-sales ratios.

Relatively speaking, IWM is remarkably cheap compared with SPY. The numbers look like this: SPY sells at 21.7 times trailing 12-month earnings and 2.5 times trailing 12 months sales, versus IWM’s 12.1 times and 1.1 times, respectively. It should be slam-dunk for small caps versus large caps over the next several years, at least on paper.  

The other potential boon to small-cap stocks versus larger companies is for the worst reason of all. Specifically, the thing that forces us to try hard to separate from our sentiments as humans from our obligations to invest assets: war.  

Israeli-Hamas War in the Mix 

The Israeli-Hamas war, in addition to the war between Ukraine and Russia, have more potential to disrupt the earnings of larger stocks than smaller companies, because larger firms tend to be more global in nature. Small caps get more of their revenue from the U.S., which at a time of high geopolitical strife, is an advantage.  

But of course, there’s more to the story. IWM is far from a clean index. It sets the bar low from a company quality standpoint, making those valuation figures less trustworthy than if the Russell 2000 Index didn’t contain so many vulnerable businesses.  

Higher interest rates are the root cause, as they jack up the borrowing costs for these businesses, many of which rely heavily on debt to keep growing. This is reflected indirectly in IWM’s forecasted cash-flow growth of only 2.4% versus 7.9% for SPY.  

Small-Cap ETFs 

There are many ETF alternatives to that index that also focus on smaller companies. The other very popular small-cap index is the S&P SmallCap 600, which the $64 billion iShares Core S&P Small-Cap ETF (IJR) is based on. This version of small cap stock investing avoids many of the least liquid stocks that IWM includes.  

And, for those who want to go a step further, the $3.7 billion Pacer US Small Cap Cash Cows 100 ETF (CALF) takes the S&P SmallCap 600 and filters down to just 100 stocks with strong cash flow trends. CALF then weighs its stock holdings by free cash flow, not market capitalization.  

Small but mighty could just be a new rally cry for investment advisors and investors. And with detailed information on 142 small-cap exchange-traded funds at etf.com, there’s a very large opportunity to do some homework on small-cap stocks. 

Rob Isbitts was an investment advisor for 27 years before selling his practice to focus on ETF research and education. He is based in Weston, Florida. Contact him at  [email protected] and follow him on LinkedIn.