A Better Way to Consider Small-Cap Value | ETF Trends

Historically speaking, small-cap value is a potent factor combination, though it’s languished in recent years as growth stocks topped value rivals. Amid signs that smaller stocks are starting to perk up, investors may want to revisit the small-cap value marriage with some added bonuses via the Principal U.S. Small-Cap Multi-Factor Index ETF (NASDAQ: PSC).

PSC’s underlying benchmark, the Nasdaq US Small Cap Select Leaders Index, “uses a quantitative model designed to identify equity securities (including growth and value stock) of small-capitalization companies in the Nasdaq US Small Cap Index (the ‘parent index’) that exhibit potential for high degrees of sustainable shareholder yield, pricing power, and strong momentum while adjusting for liquidity and quality,” according to Principal.

Proving that there’s something to small-cap value intersection with quality, PSC is higher by 19.65% over the past month, an advantage of 515 basis points over the Russell 2000 Index.

“The small-cap sector typically is defined as stocks with market capitalization between $250 million and $2 billion,” reports Simon Constable for the Wall Street Journal. “Value stocks are those within the sector that have relatively low price/earnings ratios. They generally tend to include shares of cyclical companies, smaller financial firms, auto-parts manufacturers, home builders, furniture companies, and chemical companies.”

Potential With PSC

While PSC has value and quality traits, it’s not short on growth opportunities as highlighted by the fund allocation roughly a third of its weight to the consumer cyclical and healthcare sectors. Adding to the near-term allure of PSC is that many market observers see reasons for small-cap value to rally.

“One reason: An uptick in revenue generally has a proportionately greater effect on operating income for small companies than it does for larger ones. That’s one reason professional investors often pick smaller companies to benefit most from an economic recovery,” according to the Journal.

While investors may flock to the relative safety of large-cap equities during a recession to lessen the blow of market volatility and to provide a cushion during a market downturn, small cap performance is worth watching as the economy exits a recession. As such, investors may want to give small cap equity funds a look now and make a value-oriented play relative to their potential gains.

“There are other reasons small-cap value stocks could shine when the economy begins to recover,” reports the Journal. “The high-yield spread already has started to narrow, to 6.5 percentage points at the end of May, showing that investors are less concerned about riskier investments. And there is historical evidence to show that as the spread reverses, the jump in share prices in the small-cap value sector can be far greater than for large-cap stocks.”

For more on multi-factor strategies, visit our Multi-Factor 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.