RWJ - RWJ: Playing Value In Small Caps Means Sacrificing Quality

2023-11-04 03:52:29 ET

Summary

• RWJ is a value-heavy smart-beta play offering exposure to a recalibrated version of the S&P 600.
• While having much stronger value characteristics than IJR, RWJ lags it on the quality and growth fronts.
• Another surprising issue is volatility, which marred an otherwise strong performance delivered since its reorganization.
• I argue against sacrificing quality for value; a rating upgrade is unjustified.

No doubt, after the iShares Core S&P 500 ETF's ( IVV ) 2.21% decline in October, which was preceded by an even more painful September when it was down by 4.7%, equity investors finally breathed a sigh of relief as the S&P 500 index has just delivered the best week of 2023 to date, buoyed by, among other things, supportive economic data and the Fed keeping interest rates unchanged for now.

But while the brisk bounce from correction territory looks promising, this certainly does not mean that value-centered strategies, including those in the smart-beta league, should be abandoned. One of the notable examples is the Invesco S&P SmallCap 600 Revenue ETF ( RWJ ). I discussed this investment vehicle for the first time in June 2021, when I opted for a neutral stance, partly because it had too small exposure to the profitability factor. Since then, RWJ's return has been subdued.

The previous three months were especially lackluster as it underperformed IVV, even despite its value tilt.

Data from Portfolio Visualizer

Today's note is supposed to provide an overdue update, with a focus on RWJ's factor exposure compared to the iShares Core S&P Small-Cap ETF ( IJR ), a fund tracking the S&P SmallCap 600 Index, and explain why I believe a rating upgrade is unjustified.

Investment strategy recap

RWJ has a smart beta strategy at its crux, with a nuanced weighting schema instead of a traditional market-cap-based one. The S&P SmallCap 600 Revenue-Weighted Index is its basis. The fund's website has the following brief description of the benchmark:

The Index is constructed using a rules-based approach that re-weights securities of the S&P SmallCap 600® Index according to the revenue earned by the companies, with a maximum 5% per company weighting. The Fund and Index are rebalanced quarterly.

As I said in the previous note, the essential advantage of the methodology is that it

...magnifies the impact revenues have on capital appreciation, thus making the fund's asset allocation more connected to the economic reality.

As the strategy is much more complicated than IJR's, welcoming significant turnover , RWJ has an expense ratio of 39 bps vs. IJR's 6 bps .

Looking at factors: p laying value in small caps means sacrificing quality

As of November 1, RWJ had 593 common stocks and REITs in its portfolio. Its largest holding with a 4% weight was World Kinect Corporation ( WKC ), which describes itself as "a leading global energy management company." Valued at $1.21 billion, WKC delivered a last twelve months revenue of $49.59 billion. By contrast, IJR's primary holding (0.7%; excluding the money market fund, which has the largest weight in the portfolio) was Comfort Systems USA ( FIX ), with a market cap of $6.68 billion; WKC was in 337th place (0.1% weight).

Expectedly, different methodologies produce different sector mixes. For example, RWJ's focus on revenue resulted in its much larger exposure to consumer discretionary, energy, consumer staples, communication, and industrial sectors. At the same time, IJR is heavier in financials, IT, real estate, healthcare, and utilities. Their allocations to materials are on par.

One essential thing investors should understand about smart-beta revenue-centered strategies focused on the small-cap universe is that in their case, unorthodox weighting schemas can deliver excellent results on the value front, especially considering smaller companies predominantly have more comfortable multiples than their larger counterparts (a phenomenon to which I have paid a great deal of attention in my ETF research notes on Seeking Alpha). However, the flipside is that quality, an Achilles heel of small caps, can become even weaker. Unfortunately, RWJ is one of the examples demonstrating that issue. To illustrate that, I have prepared the following table, with the metrics calculated using data from Seeking Alpha and the funds.

• First, we see that neither RWJ nor IJR are pure-play small-cap funds. Again, this problem is widespread among ETFs, something I have already covered in the article on the Roundhill Acquirers Deep Value ETF ( DEEP ). Investors have to either make compromises or venture into less liquid funds that do deliver on the small/micro size factor.
• Still, RWJ has a lower weighted-average market cap than IJR, partly because companies with market values in excess of $2 billion account for just 44.4% of the fund's net assets, vs. 57.8% in IJR's case.
• Next, the earnings yield. RWJ clearly has an edge, with an EY about 2% higher. The issue here is that both funds have exposure to Lumen Technologies ( LUMN ), a stock with an EY of negative 1,063%. Regardless of its weight, it distorts the portfolio-wise figure. So for the sake of consistency, I replaced all the negative EYs with zero, which still makes the results not as reliable as if all the holdings were profitable.
• Thankfully, we have other methods. For instance, the Price/Sales ratio. And RWJ beats IJR majorly, with P/S below 1x. And the above-mentioned WKC, which has solid revenues but just low single-digit margins is among the main contributors here.
• The fund's exposure to companies with no less than a B- Quant Valuation rating or higher is also telling. ~63% is one of the strongest results I have encountered to date.
• However, growth and quality are where the revenue-based smart-beta approach does not help but makes small caps' issues more acute. Already hardly spectacular in the case of the S&P 600 ETF, both my favorite capital efficiency indicators are even weaker for RWJ. And even with triple-digit negative ROA removed (Ironwood Pharmaceuticals ( IRWD ) and Xperi ( XPER )), the WA figure would only touch 3.9%.
• Certainly, less than 44% allocated to companies with at least a B- Profitability rating is inadequate; IJR is only slightly ahead.
• RWJ also lags IJR regarding growth, with both forward EPS and revenue growth rates only in the mid-single-digits.
• In sum, while RWJ's value tilt looks beneficial in the current environment, I argue against sacrificing quality for value here.

Final thoughts

RWJ is a value-heavy smart-beta play offering exposure to a recalibrated version of the S&P 600. Small-cap funds (including those with a sizable presence of mid-caps) are exposed to the issue of companies with weak margins and fragile financial positions, or even outright value traps, having an impact on their returns. Unfortunately, a revenue-based weighting schema exacerbates this problem.

Another surprising issue is volatility. The truth is, even though RWJ was capable of delivering robust performance since its reorganization in 2019, easily beating IJR and even IVV, with a 52.56% total return in 2021 being the major contributor, its strong result came with a standard deviation not all value investors would tolerate. The details are provided below.

The period is June 2019 - October 2023. Data from Portfolio Visualizer

For context, the Invesco S&P 500 High Beta ETF ( SPHB ), which has a strategy that embraces volatility, had a 31.53% standard deviation over that period.

All in all, I am not content with RWJ's quality profile, and a rating upgrade is unjustified.

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