VBR - SLYG: Small Caps In 2024 And The Bullish Case For It

2024-01-22 03:00:26 ET

Summary

• Small caps had a lackluster 2023 but saw improved performance in the last two months of the year.
• Small business optimism and positive economic trends support a bullish thesis for small caps and the SLYG ETF.
• The SPDR S&P 600 Small Cap Growth ETF is currently undervalued and poised for a strong year in 2024.

Investment Thesis

Small caps had a lackluster 2023 for the most part. Until October last year, the Russell 2000 Index ( RTY ) was losing 7% on a YTD basis, whereas the broader market was up 7% despite hitting YTD highs in August 2023. Despite inflation falling on a y/y basis and optimism among small businesses slightly rising mid-year, last year.

However, investor sentiment changed in the last two months of last year as the inflation outlook got better, followed closely by increasing hopes for rate cuts by the end of last year. Small-cap stocks were suddenly performing better than broader market indices, as captured by the RTY index in the chart below.

I believe the bullish momentum we saw in small cap stocks last year will continue this year too. The small-cap stocks, as represented by the SPDR S&P 600 Small Cap Growth ETF (SLYG), are currently undervalued, according to my analysis. I believe 2024 will be a strong year for small caps and propose a buy rating on the SLYG.

About SLYG

The assets in the SLYG fund are owned and managed by asset management giant State Street Global Advisors. Through the fund, the firm seeks to offer exposure to small-cap firms listed in the U.S. markets, with the caveat that all small-cap stocks that are part of the fund's assets must exhibit strong growth characteristics. According to SLYG's prospectus , the fund's constituents must demonstrate growth in three areas: sales growth, earnings change to price, and momentum.

SLYG achieves its fund objective by replicating the performance of the S&P SmallCap 600 Growth Index. The index uses a float-adjusted market cap-weighted method to balance the benchmark's constituents.

I have also added an overview of the fund's holdings below, and will use this to compare the fund to its peers in the next section.

Peer comparison

To understand SLYG better against its peers, I have attempted to compare the fund with some of its direct peers, while also comparing it to the larger and well-known iShares Russell 2000 ETF (IWM). Since SLYG is a growth-oriented small-cap ETF, as I noted earlier, I have also added its value-based peer ETF for investors to get a better picture for those who might want to look at it from the growth-vs.-value perspective.

The first observation I will note is that generally all the funds I have listed above are relatively cheap, between 15 cents and 19 cents, with the Vanguard Small-Cap Value Index Fund ETF ( VBR ) costing half of what SLYG costs. Another common theme here is that since there are risks that exist in investing in small-cap stocks, most small-cap ETFs attempt to spread the risk and reduce it by increasing the number of asset holdings.

The SPDR S&P 600 Small Cap Value ETF ( SLYV ) was launched at the same time as the SLYG but with a comparatively higher dividend yield. This is a key difference between the SLYG and SLYV. Since the SLYG is a growth-oriented fund, the opportunity for capital appreciation is much higher as compared to its value-oriented counterpart. This can be seen in the performance of the SLYG, which has started to look much better in shorter time frames as compared to its peers. I had noted at the start of this research how small caps started to rally towards the end of last year as the macro outlook started to get better.

Macro view supports bullish thesis for small caps

The Small Business Optimism Index is a benchmark created by the NFIB Research Center that specializes in reporting economic trends among small businesses. The benchmark is based on survey responses collected by polling small businesses on ten seasonally adjusted components such as labor, spending, revenue, earnings, inflation outlook, etc.

Per the latest observation last month, the Optimism index rose 1.3 points to 91.9, climbing to a seven-month-high, as can be seen in the chart below.

I also added three more benchmark components to the charts above that support the bullish narrative for small-cap stocks and the SLYG. While small business confidence rose, pessimism about the economic outlook diminished sharply, with both sales expectations and earnings expectations improving at the same time.

The positive trends that have been building in small businesses formed the basis for many other market participants to upgrade their bullish outlook for small caps. For example, investment firm UBS noted the same trends that I observed in the NFIB Optimism Index while adding:

Our expectation for 9% earnings growth for the S&P 500 in 2024 suggests low-double-digit earnings growth for the S&P 600 small-cap index.

As per State Street's latest update last week on the SLYG, the fund trades at a forward PE of ~14.8. Layering in the earnings estimates that UBS analysts noted, I will assume that earnings are expected to grow at ~12%. Given that the S&P 500 trades at a forward PE of 19.5 with expectations to grow earnings by ~9%, I strongly believe there is significant room for multiple expansion in SLYG.

Risks to bull thesis

The biggest risk when it comes to investing in the SLYG is associated with broader risks to the entire small-caps sector. My thesis is based on the premise that we do not see a recession or a slowdown in 2024. So far, most economists are calling for 1.5%-1.9% GDP growth, like Goldman Sachs, the Conference Board , etc.

Small businesses are the most susceptible to downturns in the economy. This is because small businesses are more restricted in securing capital resources and financing to fund their growth. Slowdowns will also put pressure on consumers who spend less, creating a more pessimistic environment for small businesses, as represented by the SLYG, to operate, thus putting downward pressure on the revenues and earnings of small businesses. A surprise upturn in inflation may also impact small businesses, as represented by the SLYG, since the Federal Reserve will be forced to keep raising rates, making it more expensive for small businesses to access financial capital.

Takeaways

I believe there is still pessimism in the small caps complex of stocks, and SLYG is being subjected to unnecessary multiple compression as a result. There may be some volatility in the first quarter of the year, but with earnings for the small caps stocks set to grow faster than the S&P500 index, the stage is set for the small caps represented by SLYG to rally in 2024. I rate the SLYG ETF as a strong buy.

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