Historically, small cap stocks trade at elevated valuations relative to their large cap peers, but many put up with the prices in the name of accessing above-average growth potential.
Compounding the small cap valuation conundrum is how some indexes of smaller stocks are constructed. Put simply, some exclude companies that aren’t profitable. While that sounds positive, it actually skews valuations lower, giving the appearance of value.
“However, when calculating the price-to-earnings ratio, analysts sometimes—as in the figures just cited—cut out the companies that don’t turn a profit,” reports Karen Langley for the Wall Street Journal. “This can have a dramatic effect on how pricey a broad swath of the market appears, especially since the share of the small-cap index without profits, high to begin with, surged in the aftermath of the pandemic-induced recession.”
Investors looking for a more accurate interpretation of value with smaller stocks may want to examine the Invesco S&P SmallCap 600 Pure Value ETF (RZV). That $281 million exchange traded fund follows the S&P SmallCap 600® Pure Value Index, which measure value “by the following risk factors: book value-to-price ratio, earnings-to-price ratio and sales-to-price ratio,” according to Invesco.
RZV lives up to its value billing with a forward price-to-earnings ratio of just 14.85x, according to issuer data. Home to 165 stocks, the fund’s lineup is broad enough to provide an accurate representation of small cap value while not excluding companies solely on the basis of profitability.
“For the Russell 2000 benchmark, leaving out the unprofitable companies means setting aside what for the past year has amounted to more than one third of the market value of the small-cap index, according to an analysis from Jefferies looking at earnings over the previous 12 months,” according to Journal.
RZV also offers some sector-level diversification benefits. For example, the the S&P 500® Pure Value Index devotes almost 45% of its weight to financial services stocks while the small cap RZV has a 20% weight to that sector.
The ETF also features double-digit allocations to four other sectors while the the S&P 500® Pure Value Index has just one – financial services.
The fund is up almost 68% over the past year, as opposed to a 38.37% gain for the Russell 2000 Index over the same period.
For more news, information, and strategy, visit the ETF Education Channel.
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.