2023-07-05 20:58:18 ET
Summary
- FNDA holds nearly 1,000 small-cap stocks and weights them according to four screens: adjusted sales, cash flow, dividends and buybacks, and book value and intangibles.
- FNDA has a 0.25% expense ratio, average for the category. However, small-cap ETFs is one category you should be willing to pay up, so it's not a dealbreaker.
- Higher-fee ETFs tend to have smart profitability screens, but I was disappointed to find FNDA has a below-average profitability score. This article presents some alternatives to consider.
- Current fundamentals aren't that impressive, especially on earnings momentum. Therefore, while FNDA is an improvement over many small-cap funds, I don't see the appeal today.
Investment Thesis
The Schwab Fundamental U.S. Small Company ETF ( FNDA ) is a fundamentals-based small-cap fund with a decent long-term track record dating back to August 2013. Unfortunately, its screening process doesn't substantially improve the portfolio's profitability score, making it a less-than-optimal choice for investors seeking small-cap exposure. As an alternative, I will highlight FNDA's fundamentals alongside other funds like the Pacer US Small Cap Cash Cows ETF ( CALF ) and demonstrate that low-cost passive funds aren't always your best bet when investing in the small-cap segment.
FNDA Overview
Strategy Discussion
FNDA tracks the Russell RAFI US Small Company Index, which attempts to improve on the returns of traditional cap-weighted Indexes by assigning more weight to a company's fundamentals rather than size. The Index Page summarizes the strategy as follows:
The strategy engages in contrarian rebalancing, meaning that it tilts towards out-of-favor stocks trading at more attractive valuations. Furthermore, the Index Fact Sheet notes how security weights are determined using four fundamental measures:
- Adjusted Sales
- Cash Flow
- Dividends and Buybacks
- Book Value and Intangibles
Although I'm not a contrarian investor, these screens should yield a relatively high-quality portfolio. Profitable companies tend to have high sales and cash flow. It's also likely that only profitable companies are routinely paying dividends and engaging in share purchases. And finally, the abstract of this research paper suggests a positive relationship between intangible assets and various measures of profitability, including return on assets, return on capital employed, and gross margin. In previous research, I found that profitability is where most plain-vanilla small-cap ETFs struggle, so I'm excited to see what FNDA offers. But first, let's analyze performance.
Performance Analysis
FNDA has outperformed the average small-cap blend ETF since its August 2013 launch, delivering a $11,930 profit through May 2023 on an initial $10,000 investment compared to the $8,894 average for the category. It also outperformed the Russell 2000 Index, tracked by VTWO and IWM .
However, the Russell 2000 Index is a fairly easy benchmark to beat. More concentrated Indexes with a built-in profitability screen, such as ETFs tracking the S&P SmallCap 600 Index ( SPSM ), tend to have better track records. Still, FNDA has beaten both IWM and SPSM since September 2013.
Finally, consider this 35-ETF sample of small-cap blend funds below. The table shows each fund's expense ratio, annual returns between 2014-2023, and the average return between 2019-2023 through June. I've also included FNDA's percentile ranking for each statistic in the bottom row, with a lower figure indicating a better result.
Based on this sample, FNDA ranked in the first quartile in 2014 and 2021 but ranked in the third and fourth quartiles in 2017, 2018, and 2020. Otherwise, it performed slightly above average. Notably, between 2019-2023, FNDA was a top-quartile performer. This comes despite a 0.25% expense ratio that's only average for the category. Many investors start their search by narrowing selections to only the least expensive, but that's a mistake for small-cap stocks. The cheapest funds tend to have no quality screens, and lately, more expensive ones like CALF have emerged that have demonstrated they can deliver alpha over time.
FNDA Analysis
ETF Composition: Sector Exposures and Top 10 Holdings
The following table highlights sector exposures for SPSM, IWM, CALF, and FNDA. With nearly 1,000 holdings, FNDA is sufficiently diversified and well-balanced across all sectors. Currently, it's led by Industrials (21%), Consumer Discretionary (15.5%), and Financials (15%).
CALF is less of a core holding and more complementary. You can see how it's highly concentrated in Consumer Discretionary (26.5%), Industrials (21%), and Energy (20%). Still, you might choose to bundle it with a broad-based small-cap fund, and that's how I will analyze FNDA today.
Before that, I've listed FNDA's top ten holdings below. However, this list does not explain the fund well, as the allocations total only 3.32%. Still, the list is proof that FNDA is fundamentally-weighted. Super Micro Computer (SMCI) and Entegris (ENTG) have market caps of $13.1 billion and $16.6 billion, while Diversified Health Care Trust ( DHC ), FNDA's top holding, has a market cap of only $550 million.
FNDA Fundamentals
I've listed FNDA's fundamentals for its top 25 industries in the table below, which covers 45% of the fund. As comparisons, I've also listed summary metrics for SPSM, IWM, and CALF in the bottom rows.
A few observations:
1. I'm disappointed in FNDA's 6.17/10 Profitability Score. Despite the four screens that should lead to a better score, it trails SPSM's 6.28/10 and is only marginally better than IWM. Plenty of Regional Bank stocks weren't screened out, likely due to no ROA screen. Earlier this year , I demonstrated how the OUSM avoided that industry with this simple screen, and as a result, its profitability score is solid at 7.37/10.
2. FNDA differentiates itself from other small-cap funds by allocating more to larger companies, as indicated by its $5.14 weighted average market capitalization figure. SPSM and IWM are only $2.58 and $2.89 billion, while CALF is the lowest at $2.39 billion. Again, the reason is FNDA's screening process, which naturally tilts toward more established companies with higher sales, cash flow, dividends, and book value.
3. FNDA has a 1.27 five-year beta, similar to SPSM and IWM. It's a reminder that small-cap stocks are generally more volatile, so they may not be suitable for defensive investors.
4. I don't find FNDA's growth and valuation combination attractive. Its estimated earnings growth rate is only 6.50% compared to 7.40% for SPSM, and it trades at a slightly higher forward earnings valuation (20.21x vs. 19.79x). IWM has the best 9.21% earnings growth rate of the three core funds, typical of an ETF with more unprofitable stocks. However, it's a bit more expensive at 21.07x forward earnings. It would be higher since 24% of IWM's companies have negative estimated earnings (and thus, no P/E included in the calculation), vs. just 14% for FNDA. This is one example of how valuation ratios are often misleading for small-cap ETFs.
5. FNDA has the weakest Seeking Alpha EPS Revision Score at 5.43/10. Regional Banks are a key source, as the industry has yet to recover from the crisis that started with the collapse of Silicon Valley Bank. The SPDR S&P Regional Banking ETF ( KRE ) is still off 27.62% on the year.
Small-cap stocks do not have strong earnings momentum, which will likely be a short-term headwind. To illustrate, the median EPS Revision Score for small-cap blend ETFs is currently 5.63/10, slightly better than FNDA's score. However, Wall Street is more optimistic about other segments. I've listed the scores for the 12 size and style categories below.
- All-Cap Value: 5.72/10 (Sample: 13)
- All-Cap Blend: 6.22/10 (Sample: 71)
- All-Cap Growth: 6.52/10 (Sample: 6)
- Large-Cap Value: 5.97/10 (Sample: 35)
- Large-Cap Blend: 6.21/10 (Sample: 146)
- Large-Cap Growth: 6.34/10 (Sample: 34)
- Mid-Cap Value: 5.75/10 (Sample: 10)
- Mid-Cap Blend: 5.80/10 (Sample: 34)
- Mid-Cap Growth: 5.98/10 (Sample: 14)
- Small-Cap Value: 5.39/10 (Sample: 16)
- Small-Cap Blend: 5.63/10 (Sample: 46)
- Small-Cap Growth: 5.89/10 (Sample: 12)
FNDA is either a small-cap value or small-cap blend ETF, and those categories have the two lowest EPS Revision Scores. Therefore, selecting these types of ETFs is contrarian, which the ETF provider acknowledges. My counterpoint is that stocks often trade at low valuations for a reason, and you may end up underperforming by ignoring these sentiment scores. We've seen it this year, with small-cap value and blend ETFs delivering median 4.99% and 6.83% returns through June, while all-cap and large-cap growth ETFs are up 23.32% and 28.01%. That's a big gap to make up.
Investment Recommendation
I don't support buying FNDA today. Although its historical returns are solid, its fundamentals aren't attractive compared to core alternatives like SPSM. More importantly, small-cap stocks are out of favor, and I'm not a contrarian investor. Thank you for reading, and I look forward to answering any questions you have in the comments section below.
For further details see:
FNDA: Should You Buy This Fundamentals-Focused Small-Cap ETF?