Why Small Caps Should Have A Place In Your Portfolio And How To Invest In Them

As large cap growth stocks account for most of the major market gains, it’s no surprise they also dominate investors attention and portfolios. But, people may be overlooking what has historically been a key to diversification and catalyst for steady long term returns; namely the universe occupied by small cap stocks.

A small cap company is typically defined by having a market capitalization ranging from approximately $300 million to $2 billion. Below that threshold it is considered a micro-cap and many institutional funds (pension, mutual and even hedge) are prohibited through their chartered mandate from micro-caps. This means individual investors could have an advantage in unearthing small companies before the big guys can come in and pump up their valuations.

However, like many individual investors, I don’t have the time or wherewithal to scour through the nearly 3,000 publicly listed companies considered small caps.

This when Exchange Traded Funds (ETF) can provide both a cost efficient and fully vetted way to gain exposure to the group.

The best known small cap index is the Russell 2000 and the most popular ETF is the iShares Russell 2000 ETF (IWM), which has over $55 billion in AUM.

It is up some 15% for the year-to-date, very respectable, but still lagging its large cap brethren the SPY and QQQ by a whopping 10 and 21 basis points for the YTD. This is the largest discrepancy between the big three ETFs for any 6 month or longer period ever.

As you know, I’m a believer that in investing and finance things (whether it be sentiment, performance or trend) tend to revert to mean and 70 years of history suggests small caps will be due to play catch up in the next 6-18 months.

To take this one step further, right now large cap growth stocks, which are mostly tech related, such Microsoft (MSFT), Apple (AAPL) and Alphabet (GOOGL) are also among the most expensive stocks in the market trading at their highest valuations in nearly 15 years. The average P/E of the top largest 6 stocks is a whopping 32x forward earnings.

On the other hand, the IWM trades at just 12x next year’s expected earnings. And the metrics get even cheaper if you focus on the sub sector of “Value” within small caps which includes many companies trading with mere single digit P/E multiples.

I think small cap value ETFs warrant more investor attention as reasonable valuations and greater upside potential look increasingly attractive by comparison.

So, I turned to Magnifi to do some research and what some of the criteria are to be considered a “value” name and find some ETFs to provide exposure to the group.

A small cap value ETF is an exchange-traded fund that invests in small cap companies with a value investing approach. Value investing is a strategy that seeks undervalued stocks with the belief that the market has not fully recognized their true intrinsic value.

More specifically, a small cap value ETF typically includes stocks of companies that meet certain fundamental metrics such as price-to-earnings ratio, price-to-book ratio and other valuation measures. Most small cap value ETFs are passively managed, meaning they aim to replicate the performance of a specific small cap value index.

The largest small cap value ETF is the Vanguard Small-Cap Value ETF (VBR), with $26.11 billion in AUM. It is up some 13% YTD, so it’s trailing the IWM, but still beating out 70% of other small cap value funds.

I queried Magnifi to “Find the best performing small cap value ETFs with a track record of at least three years.”

There are a handful that are not only up from 15%-23% this year but have posted average annual double digit returns over the past three years. Given the value nature of their holdings these funds also rank in the top quintile in terms of safety, making their risk/reward profile attractive.

Here are two names that stood out to me:

Pacer US Small Cap Cash Cows (CALF) with $2 billion AUM, seeks to track the total return performance of the Pacer US Small Cap Cash Cows Index, minus expenses which come at a reasonable 0.59% ratio. Under normal circumstances, at least 80% of the fund’s total assets (exclusive of collateral held from securities lending) will be invested in the component securities of the index. The index uses an objective, rules-based methodology to provide exposure to small-capitalization U.S. companies with high free cash flow yields.

During the current environment of high interest rates it seems wise to focus on companies with strong free cash flow as they will be able to fund their operations and hopefully growth without taking on onerous debt.

CALF is up an impressive 25.3% for the YTD.

The second name I want to highlight is WisdomTree U.S. Small Cap Quality Dividend Growth Fund (DGRS), which has $255 million under management and an attractive 0.38 expense ratio.

DGRS’s construction scheme whittles down the 2,000 dividend-paying companies to 25% stocks with the lowest capitalization that have growth and quality characteristics. Specifically, the fund screens for funds with strong long-term earnings growth expectations, and strong historical return-on-equity and return-on-assets. This process creates some sector tilts and a style bias—toward value not growth. Stocks projected to pay more dividends are weighted more heavily based on their most recently declared dividend per share.

Overall, investing in small cap value ETFs offers distinct advantages, such as potential for outperformance and a value investing approach, but they also have associated disadvantages, such as higher volatility and risk.

Here are the key pros small cap value ETFs:

• Potential for higher returns: Small cap value stocks have the potential for significant long-term growth.
• Diversification: Small cap value ETFs provide investors with exposure to a broad range of small cap stocks across different industries.
• Value investing approach: The value investing strategy employed by small cap value ETFs seeks to identify undervalued stocks with potential for price appreciation.

Here are some cons:

• Higher volatility and risk: Small cap value investing can be riskier and more volatile compared to investing in larger, more established companies.
• Liquidity concerns and style drift: Some small cap stocks may have lower trading volumes and liquidity, making it harder to execute large trades at desired prices. For this reason, some small cap value ETFs extend their objectives to hold some mid-cap stocks, which may cause style drift.
• Market overlooked: Value stocks, including small cap value stocks, may remain undervalued for longer periods, and the market may not recognize their true value as quickly as anticipated.

Bottom Line:

Investing in small cap value ETFs can be suitable for investors seeking higher growth potential and exposure to undervalued companies, especially in environments where overpriced large cap growth stocks are expected to underperform. However, it’s essential to recognize the higher risks associated with small cap stocks, particularly during economic downturns.

Investors should carefully consider their risk tolerance, investment objectives and time horizon before allocating a portion of their portfolio to small cap value ETFs or any investment product.

Learn more about investing in small cap value stocks, including the associated benefits and risks, and see a list of top-performing small cap value ETFs go to Magnifi.