Good Time to Apply Quality to Small-Caps | ETF Trends

Small-cap stocks are back in style as of late, and the quality factor, well, that never goes out of style. Put it together, and now is a good time consider the small-cap/quality marriage.

Enter the Invesco S&P SmallCap Quality ETF (XSHQ), one of a small number of small-cap exchange traded funds dedicated to the quality factor. XSHQ follows the S&P SmallCap 600 Quality Index, which is the quality derivative of the widely tracked S&P SmallCap 600 Index. The current market landscape could be conducive to considering XSHQ.

“The economic outlook looks strong, which benefits small-capitalization stocks. But a few risks to economic demand are cropping up, making small-cap quality in particular a sound bet,” reports Jacob Sonenshine for Barron’s. “The U.S. economy is expected to expand at a fairly fast clip next year. The consensus estimate from economists is that the U.S. will see real gross-domestic-product growth of 4% in 2022, above the below 2% rate typically seen before the pandemic, according to Wolfe Research.”

Making the cut as a quality small-cap name is difficult because many smaller companies are sacrificing profitability in the name of growth. As a result, many traditional small-cap benchmarks are littered with companies without earnings. In other words, small-cap quality is exclusive territory, and XSHQ reflects as much with just 119 holdings, or less than 20% of what’s found in the S&P SmallCap 600.

XSHQ’s relevance is increasing at a time when many market participants are fretting about inflation — fears that are heightening at the hands of Wednesday’s reading of the Consumer Price Index (CPI).

“But risks to economic growth have recently been more pronounced. High inflation—which Wednesday’s data revealed yet again—could eat into economic demand. Meanwhile, the Federal Reserve may have to lift interest rates to combat inflation, a move that would further dent demand,” according to Barron’s.

A benefit of the quality factor is that while it’s distinct from low volatility, the former is usually less risky than other factors.

Small-cap quality equities “have the potential for high returns, yet they largely pose less risk than lesser-quality small-caps. The ‘quality’ element means the companies enjoy predictable and plentiful cash flows and have strong balance sheets, giving them flexibility to borrow money at better terms,” adds Barron’s.

As for how small-cap quality looks at the sector level, XSHQ allocates 39.5% of its weight to financial services stocks with the industrial and consumer discretionary sectors combining for over 41%.

Quality stocks can exhibit either growth or value traits. To that end, XSHQ devotes 15% of its weight to small-cap growth stocks and 28.46% to smaller value equities.

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The opinions and forecasts expressed herein are solely those of Tom Lydon, and may not actually come to pass. Information on this site should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation for any product.