XLF - Schwab U.S. Small-Cap ETF: Poor Risk-Reward Ratio

2023-07-21 07:11:43 ET

Summary

• Small-cap stocks are risky but potentially high-growth investments. Schwab U.S. Small-Cap ETF is a safer investment option for entering this segment but we foresee risks for retail value investors.
• Small-cap stocks are vulnerable to various factors, including financial maneuvers, political changes, and macroeconomic issues, and they have fewer resources to cope with disasters compared to larger companies.
• Many of the positives about small-cap stocks are already factored into the high price of the ETF shares with limited opportunities for growth that benefits investors at this time.

Small-Caps Are Risky Opportunities

Many of the stocks we cover are characterized as small-caps. We think improving economic conditions offer a potential opportunity to rekindle a bullish attitude and approach to the segment. It is risky, as we document in a recent article for Seeking Alpha and parley with talk backers about one small-cap business.

We suggest hedging any inkling to invest by considering Schwab U.S. Small-Cap ETF (SCHA). First assess the stock, its returns, risks, and potentials. We think SCHA deserves a Hold assessment at the present time. The +$45 per share price has factored in forecasts for a better second half in 2023 for small-cap stocks. The price is almost touching its 52-week high.

Small-cap stocks are risky. They are subject to whim, emotions, financial maneuvers, political vagaries, and macroeconomic issues. These factors tend to push and pull the small-cap stock prices more briskly because trading volumes are diminutive and news is sparse.

Definition

Forbes defines small-cap stocks as publicly traded companies with a total market capitalization of $300M to $2B. Writes Forbes,

Small-cap companies have the potential for high rates of growth, making them appealing investments, though their stocks may experience more volatility and pose higher risks to investors.

With the advent of the Russell 2000 Index of ~2,000 small-cap stocks, created in 1984, and the Dow Jones U.S. Small-Cap Total Stock Market Index, awareness of and interest in small-cap stocks grew. Indexes and ETFs became a benchmark of the economic landscape. Small-caps had tough pre-pandemic years and worse times during the novel COVID virus attack . Inflation followed eating into revenue and earnings small-caps could little afford.

In our experience, small companies have fewer resources to cope with disasters:

• They run with tighter labor forces than large employers.
• They critically depend on experienced employees to show up for work.
• Lay-offs cut deeper into production efficiencies in small companies.
• Cash reserves in small-cap companies are slimmer and burn faster when revenue slows.
• They have less influence with suppliers to ship them goods when supply chains tighten.
• Small firms hold less inventory curtailing timely order fulfillment compared to larger firms.
• Share prices meandered for a long time, then took an extra hard beating during the pandemic.

Emerging from the pandemic, many still cope with financial fragility; for instance, companies with less market power, lower earnings, slower-moving inventory, and less cash flow from operations slam into epochal declines in borrowing opportunities.

Proceed With Caution

Keep in mind, small-cap stocks are vulnerable to volatility. Schwab U.S. Small-Cap ETF has a Beta of 1.03. Last year, the consensus for 2023 EPS estimates for U.S. small-caps dropped 15.9% between January through November 30, 2022; it dropped only 5.4% for large-cap estimates. 8 months later, small-cap stocks are viewed more favorably .

The upsurge among small-cap stocks proves the point:

Profile

The Schwab U.S. Small-Cap ETF is managed by Charles Schwab Investment Management, Inc of The Charles Schwab Corp (SCHW). Schwab has a $120.2B market cap with +9% revenue growth Y/Y. Schwab ended the latest quarter with $8.02T in client assets, rising from $7.58T in its first quarter. Equity buys outstretched sell orders at Schwab by 20%, and the company added 1M new brokerage accounts in its second quarter. It appears the bulls are back, according to Schwab's CEO.

The ETF investments are in U.S. public equity markets, growth, and value stocks across diversified sectors. Formed on November 3, 2009, the ETF tracks the total return of the Dow Jones U.S. Small-Cap Total Stock Market Index by generally investing in stocks that are included in the Index . The index includes the small-cap portion of the Dow Jones U.S. Total Stock Market Index actually available to investors in the marketplace. The ETF invests at least 90% of its net assets in these stocks.

Last May, another analyst rated the Schwab Small-Cap ETF a Sell. It "underperforms because it holds many low- or non-profitable stocks" among its 1750 small-cap holdings. Assets then totaled $13.34B. Assets approaching the third week of July '23 are up to almost $15B. We are not going to dissect the holdings of the ETF. That's between management and their investors.

We like Schwab because the parent company is a proven entity. Small-cap stocks began ticking up in 2022 but in 2023 are holding; they do not perform as heartily as large-cap stocks:

Positive Factors

Small-cap companies have some advantages over bigger companies. Small-caps can emerge from crises less scathed than larger firms and private businesses. The type of crisis seems to matter little whether a pandemic, inflation, or recession. Management has flexibility, the instinct to survive, and fewer capital requirements to survive. One of my business professors tagged the survival instinct of small company operators as rat-like cunning.

The Schwab U.S. Small-Cap ETF share price is up 9.2% over the last 12 months, about 13% YTD. America's largest bank told the press in February '23 that clients are selling stocks and buying ETFs. It appears that a portion of these folks are moving into Schwab's ETF; it certainly is not for the 1.36% dividend yield.

Seeking Alpha's Quant Rating of the ETF's stock moved from wavering between Hold and Sell during the first 5 months of '23 to a Hold assessment and now Buy rating. Momentum is up, management consistently holds the line on expenses and risks, and liquidity thrives. Analysts highlight the ETF's annual operating expenses are 0.04%, "making it the least expensive products in the space," as Zacks Equity Research recently claimed .

Moreover, the ETF has a healthy mix of industries in its portfolio. YTD, industrial stocks are up and assigned a Buy Quant Rating. Technology Select Sector is +44% YTD with a Strong Buy assessment. Financials are up ~8% for the year. PE ratios overall for small-cap stocks add to our enthusiasm. Yardeni Research compares the forward price-to-earnings ratios ; the large-cap index currently is 19.7 to the forward multiple while the small-cap index is 14.1. The valuation gap between the two indexes is the widest in years.

Takeaway

Schwab U.S. Small-Cap ETF™ holdings breakdown like this:

We have liked and invested in industrials for the last 24 months and appreciate the spread of holdings though the ETF's average return has been below average over the years. Schwab U.S. Small-Cap ETF also has experienced robust volatility racking up a high Beta of over 1. Forecasts that small-cap stocks will do better in the second half of 2023 seem to us already factored into the ETF share price selling near its 52-week high of $46.60, up from about $37. We like the stock but it is risky and we tag it a Hold Rating.

Small-cap stocks are at an attractive entry point, as the economy improves. Inflation is down, talk of a recession is on hold, and supply chain issues are loosening. If interested, the safest way for retail value investors to participate in a potential small-cap resurgence is through an ETF. Any price dip into the low $40s again, we believe, can be an opportunity but SCHA shares hold too much risk for any appreciable ROI that will significantly benefit small investors.

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