EFA - iShares MSCI EAFE Small-Cap ETF: Bounce In The Cards

Summary

• SCZ has underperformed U.S. stocks and global stocks.
• SCZ offers good value relative to other segments around the world.
• Investors should be mindful of the SCZ portfolio’s elevated exposure to Japanese equities.

If you don't go out on the branch, you're never going to get the best fruit. - Sarah Parish

The iShares MSCI EAFE Small-Cap ETF ( SCZ ), with $9bn in assets under management ("AUM") and a listing history of close to 25 years, is one of the more popular foreign exchange-traded funds ("ETFs") around. SCZ covers over 2300 stocks and offers excellent diversification, with no single stock taking up more than 0.35% of the total portfolio. For the uninitiated, SCZ's tracking index, which comprises small-cap stocks, is a subset of the MSCI EAFE IMI, a broad-based index that covers developed market stocks outside of the U.S. and Canada.

Admittedly, SCZ has been out of favor for much of this year, losing close to 30% of its value. It has underperformed not just the S&P 500 Index (SP500), but also a portfolio of global stocks.

However, if you've kept track of the developments on the timeline of The Lead-Lag Report, you'd note that I've been advising investors to consider some of the more beaten-down segments of the market, as we're currently in the midst of a melt-up environment.

Those who subscribe to my private research services would note that two of my inter-market signals currently favor risk-on investing, and I think something like an SCZ could benefit from the conditions we're currently witnessing.

I can understand if some investors are apprehensive about turning bullish, as the pessimistic environment for much of 2022 has likely had a subliminal effect on their psyche and forced them to be defensive, even when conditions dictate that they should be pursuing an alternative course of action. If you're keen to better understand the nuances of what I'm saying here, you may consider listening to one of my recent talks on The Lead-Lag Live portal with David Cox.

If you're willing to look beyond the banal headlines that typically only focus on the mega-caps narrative, do consider that market breadth has turned for the better, value and cyclicals have been leading, junk bonds have been outperforming investment-grade debt, and most importantly, the small-cap cohort has been attracting a lot more capital than large-caps.

It's also worth noting that historically, the November to April period has - on average - been a very lucrative period for risk assets.

Nonetheless, within the small-cap space, I believe SCZ is finely positioned.

Firstly, it appears that this segment offers better value than U.S. small-caps. Note the chart below, which compares the performance of developed market small-caps (ex-U.S. and Canada) and small-caps from the S&P 600.

Granted, the former has been losing clout relative to the latter for more than a decade now, but even in this long downtrend, there have been intermittent periods when things have reversed.

Nonetheless, currently, the ratio between these two segments is intriguingly poised along the trendline support and could see a bounce from here which would be good for SCZ.

One can also consider looking at the developments on SCZ's long-term chart. Note that the price has now dropped to the lower line of its long-term channel, which could offer useful support.

Also note that SCZ's valuations are not prohibitive when you compare them to other pockets around the world. Currently, SCZ's large portfolio only trades at a weighted average P/E of 9.9x and a P/S of less than 1x (0.74x to be precise). Conversely, if you look at the iShares MSCI EAFE ETF ( EFA ), valuations are pricier with corresponding P/E and P/S multiples of 11.4 and 1.16x.

Finally, I would also point to prospective currency dynamics which could aid SCZ's positioning. As noted in the "Leaders-Laggers" section of my subscription research, I suspect we've seen a short-term top with the dollar. I don't believe we are anywhere close to a Fed pivot, and we will likely see another 75bps hike this week. However, the dollar may come under further pressure, if Powell signals his intention to re-evaluate the ongoing aggressive stance from the December meeting onwards. This could set the tone for a lot of global currencies to rally.

Risks

Perhaps the biggest turnoff of SCZ's portfolio is its sizeable exposure to Japanese equities, which account for over 30% of the portfolio (twice as much as the next biggest region). As I've noted in my global piece this week, the Japanese central bank's relentless interventions in the forex market have caused some uncomfortable price swings and volatility. It is questionable if it has had the desired impact.

Given these currency shenanigans, even if one were to see an improvement in the prospects of some of the Japanese stocks, foreign investors would likely remain cagey. Latest data show that foreign investors have sold close to $500bn yen worth of Japanese stocks over the last two weeks.

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