IJT - IJT: Interest Rate Risks Are Unsupportive Of Growth Style

2023-03-11 06:53:32 ET

Summary

• IJT targets U.S. small caps capable of delivering strong sales, EPS growth, and momentum, selected from the S&P 600 index.
• Nevertheless, upon deeper inspection, IJT is a mid-cap-heavy fund despite its small-cap focus; in the current iteration, it is overweight in IT (18.8%), industrials (18.5%), and financials (15.4%).
• It has easily trounced IVV since its inception, clocking an 8.9% annualized total return.
• It does have meaningful growth characteristics, with valuation not being as horrible as an investor familiar with multiples typical for the growth stock league might expect, though still fairly generous.
• With the backdrop being supportive of more sizeable interest rate increases, I would recommend proceeding with extreme caution. IJT is a Hold at best.

Contrarian investors might be considering utilizing current market softness driven by inflation and interest rate worries once again reignited by fresh economic data and go long growth equities before it is too late. One of the options for them is the iShares S&P Small-Cap 600 Growth ETF ( IJT ), a passively managed fund targeting U.S. small caps capable of delivering strong sales, EPS growth, and momentum selected from the S&P 600 index.

IJT has had an upbeat start to 2023, yet the momentum has obviously been lost recently amid market turbulence.

And risks for growth-centered strategies are still aplenty. In my opinion, IJT is hardly a perfect option to consider right now. Let me elaborate on the pros and cons below in the article.

What is IJT's investment strategy?

According to the fund's website , it tracks the float-adjusted market cap-weighted S&P SmallCap 600 Growth Index. As described by the index provider, constituents are selected using "sales growth, the ratio of earnings change to price, and momentum," with rebalances following a quarterly schedule. This is a minimalist trio, yet potent enough, as I will discuss below in the note.

An essential remark to make here is that IJT is not a hardline growth ETF, unlike its smaller peer Invesco S&P SmallCap 600 Pure Growth ETF ( RZG ), so there is a strong possibility that adequately valued stocks could also be found in its basket (more on that shortly).

What bulls say

Quality is comparatively strong by small-size equity universe standards

As of March 7, IJT had 372 holdings, with the principal ten accounting for less than 10% and the weighted-average market capitalization standing at about $2.75 billion, as per my calculations. Here, it goes without saying that it would be a bit of an exaggeration to say this basket is a textbook example of a small-cap portfolio as in reality, over 68% of its net assets is allocated to mid-caps (less than $10 billion, but above $2 billion in market value), so their impact on factor exposure and consequently on its returns is not to be underestimated. It should be noted that the Invesco S&P SmallCap 600 Pure Value ETF ( RZV ) which has as a similar selection universe, though does the opposite picking the most undervalued names from it, does not have that issue, with the WA market cap of just ~$1.26 billion in February when I covered it the previous time.

This matter might be regarded as a disadvantage by investors who are on the lookout for pure-play small-cap portfolios (i.e., with no mid-size stocks at all and the median market cap closer to $1 billion) as this also could result in more generous valuations across the basket than they would tolerate (I will return to that shortly). Nevertheless, this appeared to be a tailwind for quality, and I believe that the growth screen also indirectly contributed.

More specifically, with 62% of the net assets allocated to companies with no less than a B- Quant Profitability rating and a quarter of them even being A-rated (including A- and A+), IJT is not as dramatically short of quality holdings as an investor might suggest upon cursory inspection.

Most importantly, I found out that only 6.3% have a D+ rating and worse, which is rather adequate, especially for a fund tracking an index with no profitability screens except for the simple one incorporated in its parent index (i.e., the S&P 600 shuns companies which are incapable of delivering positive net earnings). Still, there is something to dislike on the cash flow side as 5.8% of the holdings (ex-financials) struggle to deliver a positive net operating cash flow; anyway, this is comparatively acceptable.

Next, I do not see a too-wide spread between the weighted-average Return on Equity and Return on Assets, the one that might be indicative of debt levels being intolerable. In the case of growthier companies, especially those with negative cash flows, overleveraged balance sheets mean there is an extreme risk that the music can stop abruptly at some point. However, with ROE of 12.7% and ROA of 7.2%, as per my calculations, I believe that most holdings have more or less adequate capital structures.

IJT mostly lives up to expectations with strong growth stories present

There are growth and value funds that are "growth" and "value" in name only. This is not the case with IJT. My calculations show that the weighted-average EPS forward growth rate stands at 18.5%, which is fairly strong; please take notice that this figure does not include companies that are loss-making at the moment and those with no analyst estimates available. The downside here is that the WA sales growth rate is only marginally above 10%, which is fine but not excellent.

IJT has outperformed IVV since its inception

IJT has a glorious history, with returns delivered since its inception in July 2000 being much stronger compared to the iShares Core S&P 500 ETF ( IVV ). The table below covers the August 2000 - February 2023 period, with iShares S&P Small-Cap 600 Value ETF ( IJS ) and iShares Core S&P Small-Cap ETF ( IJR ) added for better context.

Created by the author using data from Portfolio Visualizer

However, 2022 was a year to forget for IJT as it fell ~21.3%, which once again highlights that the growth-centered investment vehicles are hardly a top choice to navigate the capital shortage era.

What bears say

The risk of the capital shortage era remaining here for longer dents risk appetite

As IJT targets growth players, it does not come as a surprise that its holdings have a valuation problem.

For instance, my calculations reveal that its weighted-average earnings yield is at about 6.5%, a level rather surprising for a growth portfolio as I expected a low-single-digit figure; for better context, the S&P 600 index currently has ~8.3% (an 11.99x Price/Earnings ). Nevertheless, this valuation is still risky.

As ~15.4% of the fund's net assets are allocated to financials, it is complicated to calculate the weighted-average EV/EBITDA ratio. So I decided to use the method I applied in the case of the ProShares Russell 2000 Dividend Growers ETF ( SMDV ) recently . Specifically, I removed financials from the equation and redistributed their weight equally between the remaining holdings. In this theoretical portfolio, the EV/EBITDA ratio would be 15.3x and Return on Total Capital would stand at ~12%. This might look adequate, but I believe that for smaller-size companies, this is a bit too generous.

Finally, the principal problem here is that almost 45% of the holdings have a D+ Quant Valuation grade and worse, which is acceptable for large caps, but is extremely large for a portfolio with a WA market cap of ~$2.8 billion. And as fresh economic data which adds to the risk of the interest rates edging much higher has stultified the early 2023 rally, I believe the possibility of IJT to continue sliding is too high to consider buying into it right now.

Investor Takeaway

IJT is a mid cap-heavy fund despite its small-cap focus; in the current iteration, it is overweight in IT (18.8%), industrials (18.5%), and financials (15.4%).

It has easily trounced IVV since its inception, clocking an 8.9% annualized total return. It does have meaningful growth characteristics, with valuation not being as horrible as an investor familiar with multiples typical for the growth stock league might expect, though still fairly generous.

With that being said, I highlight that for the growth league, especially its mid-cap part, the nearest future is hardly cloudless. With the backdrop being supportive of more sizeable interest rate increases, it is plausible to assume that the growth premium will shrink across the board. That is to say, I would recommend proceeding with extreme caution. In this regard, IJT earns only a Hold rating from me today.

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