Summary
- FNDA's fundamentally driven portfolio offers better ROE, better earnings growth, and is cheaply valued.
- FNDA’s exposure to industrials should be noted.
- Small-caps have demonstrated useful alpha generation qualities during bear markets.
Big things are often just small things that are noticed. - Ed Kennedy
Paid members of The Lead-Lag Report would note that last week, I published a research piece highlighting the resilience of the US small-cap universe. The Schwab Fundamental US Small Company Index ETF (FNDA), which uses a few fundamental gauges such as adjusted sales, retained operating cash flow, and shareholder returns (both dividends and buybacks) to construct its portfolio, has gotten off to a decent start this year. In effect, you're looking at a portfolio with a weighted average ROE (Return on Equity) of 13% , twice as much as the Russell 2000 index.
Schwab Asset Management
Besides, on a YTD basis, FNDA has outperformed its bigger counterparts, as represented by the Schwab Fundamental US Large Company Index ETF (FNDX) by 2.5x
Besides near-term momentum, it also helps that FNDA's biggest sector exposure is towards the industrials segment. As noted in a tweet on the timeline of The Lead-Lag Report, after a few weeks of sustained weakness, the industrial ratio is attempting to make a reversal as investors look for suitable avenues to exploit the reflation theme.
Twitter
The latest US Manufacturing PMI numbers for Feb were relatively encouraging for the industrials sector, even if some of the internals are still wobbly. While the PMIs still point to contraction mode (less than 50), it appears as though things may have bottomed out in December-2022 with February's number coming in almost 1 point higher than Jan's number (which was higher than the Dec reading). Besides manufacturing backlogs too appear to be diminishing, even as employment levels rose at their fastest pace since Sep last year.
Speaking of employment, that's a risk that could weigh heavily on the cost base of the smaller businesses in US. As flagged in a tweet with the super followers of The Lead-Lag Report account, wage growth in December was at the mid-single-digit mark, well above pre-pandemic levels.
Twitter
Meanwhile, with elevated inflation, these small entities won't quite have the same pricing power as large entities to pass on wage cost increases, particularly as recessionary conditions are hardly ebbing. If anything, the New York Fed's recession probability index continues to gain steam, growing by 21% from the previous month.
With inflation the way it is, a rebound in retail sales, and a tight labor market all provide ample ammunition for the Fed to keep interest rates higher for longer. I recognize that this concoction of narratives may scare off a few investors from the small-cap thesis, but as noted in my paywalled macro piece last week, I've written about how the Fed has been notoriously slow in reacting to current conditions, with bond markets responding with greater alacrity. I believe investors would do well to not pay undue attention to the Fed's lagging rhetoric. In fact, as noted in a Twitter conversation with another member, small caps which are perceived to be more susceptible to rate hikes continue to deliver superior alpha relative to large caps. This tells you that the rate hike risk is less of an issue now.
Twitter
Even if the Fed risks tightening by too much, too late, coinciding with a period of risk-off movements in the market, investors shouldn't be overly concerned with exposure to the small-cap space. In fact, as highlighted in my paywalled macro piece last week, since 1979, there have been six separate instances where the S&P had declined in double-digit terms. Prima facie, you would think that small-caps would fare a lot worse during these eras of risk-off. But contrary to popular belief, except for 1 year, small-caps outperformed large-caps 83% of the time, demonstrating their resilience during bear market conditions.
It also helps that most of these small companies of FNDA come from the value space while large-caps are heavily dominated by growth and tech. Despite an improvement in the value-to-growth ratio since the pandemic, do consider that this ratio tends to mean-revert across decades. From 2000-2010, value outperformed growth, only for a reversal to take place in the next decade. Once again, in this new decade, we're seeing signs of what we saw during the noughties era, which bodes well for FNDA in the long run.
Conclusion
To conclude, also note that FNDA's portfolio currently offers better long-term earnings growth potential at cheaper valuations, relative to its larger peers from the Schwab Fundamental US Large Cap ETF. According to YCharts, the former trades at 13.4x forward P/E with 5-year earnings growth potential of 11.9%, whereas the latter trades at 14.2x forward P/E with earnings growth potential of 10.7%.
For further details see:
FNDA ETF: A Lot Going For It