Several Small-Cap ETFs Are Outperforming Value Stocks During the Small-Cap Rebound

This month’s market shift toward small-cap stocks is being driven primarily by a resurgence in cheaper stocks. While a rally in small caps can sometimes indicate speculative behavior, an analysis of the best-performing non-leveraged small-cap funds reveals that the value factor is leading the charge.

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According to FactSet, three of the top five small-cap exchange-traded funds (ETFs) in July are specifically focused on value. These include the iShares US Small Cap Value Factor ETF (SVAL), which was up 11.4% for the month through Wednesday, compared to a 7.4% rise for the broader iShares Russell 2000 ETF (IWM).

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The other two funds in the top five—ProShares Russell 2000 Dividend Growers ETF (SMDV) and SPDR SSGA US Small Cap Low Volatility Index ETF (SMLV)—are also cheaper than the broader small-cap sector across multiple valuation metrics, according to FactSet.

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Several factors may be driving this small-cap rally, including increasing confidence among traders that the Federal Reserve will cut rates in September. Sean O’Hara, president of Pacer ETFs, noted that profitable companies should be better positioned to handle a period of rate cuts and a slowing economy.

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Investors can gauge profitability by seeking stocks with lower price-to-earnings (P/E) ratios, a common metric used by many value funds. As of June 30, the broader IWM had a P/E ratio of 14.4, while the value-tilted iShares Russell 2000 Value ETF (IWN) had a P/E ratio of about 11, according to iShares.

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“For those small-cap companies that are not profitable, I don’t think the macro environment, Fed cuts, or even the historical underperformance of small caps versus large caps will provide much help,” O’Hara stated.

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The Pacer US Small Cap Cash Cows 100 ETF (CALF), which focuses on stocks with strong free cash flow, has underperformed the IWM in July but has outperformed over the trailing three- and five-year periods.

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However, screening for value stocks can sometimes overlook potential trouble spots in the market. Todd Sohn, ETF strategist at Strategas, pointed out that some value funds have high exposure to regional banks, suggesting that investors might want to consider active management within small caps.

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“Good managers should be able to screen out the lower-quality stocks that are not truly value but more of a trap,” Sohn advised.

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The market’s current preference for value-oriented small-cap stocks suggests a cautious optimism. Investors are gravitating toward companies that offer better value based on traditional metrics like P/E ratios. This focus on value rather than speculative growth is a sign of more disciplined investment behavior, possibly in anticipation of a more challenging economic environment.

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The broader context of this shift includes anticipation of Federal Reserve actions. The expectation of rate cuts is influencing market sentiment, as lower rates generally benefit smaller companies by reducing borrowing costs and making future earnings more attractive. However, only profitable companies are likely to navigate this period successfully, which is why investors are favoring those with solid fundamentals.

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The performance of specific ETFs like SVAL and IWN highlights the importance of value investing during uncertain times. These funds' strong performance indicates that investors are seeking stability and predictable returns. In contrast, funds with high exposure to volatile sectors or unprofitable companies may struggle, underscoring the need for careful selection.

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Active management within small caps is also gaining traction. By using a more hands-on approach, fund managers can avoid potential pitfalls and identify true value opportunities. This strategy can help investors avoid so-called value traps—stocks that appear cheap but are fundamentally unsound.

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Overall, the resurgence in small-cap stocks driven by value factors reflects a strategic shift among investors. They are looking for stability and long-term growth potential in an uncertain economic landscape. This disciplined approach may provide a buffer against volatility and enhance returns, especially if the anticipated Fed rate cuts come to fruition.

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In summary, the current rally in small-cap stocks is characterized by a focus on value, driven by market conditions and investor sentiment. Profitable, well-valued companies are leading the charge, while careful selection and active management are becoming more important. This shift underscores a strategic and cautious approach to navigating the complexities of the market.

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