Small cap and value continue to climb ferociously in November. The chart below shows that both factors have been beating tech and growth by a wide margin in the past two to three weeks.

A few days ago, I looked at the iShares Russell 2000 Value ETF (IWN) and believed it to be a good buy. The thesis was straightforward: “with the passage of time (i.e. next few months), we become closer to a vaccine, more effective treatment and instant testing, which bodes well for the economy, especially value and small cap”.

Today, I briefly revisit the idea that small cap and value might still be underappreciated today, and turn the focus of attention to a similar ETF: the SPDR S&P 600 Small Cap Value (SLYV).

ChartData by YCharts

Only the beginning

The countdown to a post-coronavirus world is not enough to justify buying small cap and/or value today. Paying the right price matters. With the recent runup in the Dow Jones and Russell 2000 indices (see chart above once again), many investors might be tempted to think that small cap value has gone too far, and that a correction is imminent.

However, longer-term context is important.

The chart below depicts a simple portfolio: long small cap value, short the Nasdaq 100 (QQQ), rebalanced quarterly. Notice that, since the dot-com correction completely flushed through the system, large tech growth has dominated. But since 2019 and especially in 2020, the outperformance has gotten a bit out of control – maybe partially justified by the new stay-at-home dynamic that is probably equal parts secular and temporary.

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Even if large tech and growth were to remain a multi-year winner over small cap value, I believe the pendulum has swung too far. Until the returns of the hypothetical long-short portfolio described above approaches the red dot on the graph below, the small cap value trade is still a promising one, in my view.

Source: Portfolio Visualizer

How SLYV is different

The SLYV fund tracks the S&P Small Cap 600 Value index, whereas IWN uses the Russell 2000 Value index as its benchmark. In theory, both indices use different criteria for determining what constitutes a “small cap value” group of stocks:

  • Size: S&P’s index looks at a universe of 1,500 stocks representing the total market and picks the 600 smallest; while Russell’s index starts from a wider universe of 3,000 stocks representing the total market and eliminates the 1,000 largest.
  • Value rank: S&P looks at three value metrics to pick its index’s value stocks (the ratios of book value, earnings, and sales to price), whereas Russell looks at only one variable (book to price).

In practice, the use of different indices results in unique portfolio profiles. First, SLYV is much more exposed to smaller stocks, since IWN brings more midcap names into the mix. Second, and probably more by chance than by design, SLYV ends up being a better balanced portfolio across the sectors.

Notice below that the SPDR fund is less exposed to financial services, the largest sector allocation, and more heavily invested in the consumer discretionary and healthcare spaces. It is perhaps this bias towards discretionary and healthcare that has led to SLYV outperforming IWN in the past decade by about 150 bps per year.

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Source: D.M. Martins Research, data from multiple ETF manager reports

The verdict

At a high level, I believe that both SLYV and IWN will perform better than the broad market over the next year or two, at least until (1) the initial phase of the economic recovery is over and/or (2) the valuation gap between small cap value and large-cap growth narrows.

However, were I to dig deeper into the details, I would favor SLYV over IWN. First, the SPDR fund is more of a pure-play bet on small cap stocks. Second, the ETF is better balanced and less dependent on financial services companies doing well. Third, the fund charges an annual management fee of 15 bps that is lower than IWN’s 24 bps.

True, IWN is a larger fund, and is about eight times more liquid than its peer. But still, I believe that SLYV is large and liquid enough to serve as a better pick between the two ETFs.

A helping hand

Stocks have been on a very choppy ride in the past few months, and the future looks even more uncertain. But my SRG portfolios have been beating the S&P 500 in 2020 and since inception, while also producing far superior risk-adjusted returns. To find out how I have created a better strategy to grow your money in any economic environment, click here to take advantage of the 14-day free trial today.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.

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