Smaller stocks have what appear to be some sustainable tailwinds, a scenario increasing the allure of ETFs, such as 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.

Small cap equities have been benefitting off the rebound from the coronavirus sell-offs back in March, but investors can’t be too optimistic by the recent momentum. The question, of course, is whether it’s sustainable.

Momentum investing can target those companies that are exhibiting high levels of growth. The momentum factor selects company stocks that have recently outperformed based on the idea that “the trend is your friend” and that stock market leaders typically continue to outperform. This type of strategy can be an effective way of targeting growth-oriented companies since stocks with positive momentum often continue to generate strong earnings.

“A study published Wednesday by the Leuthold Group showed that over time in the small-cap space, it has paid to own the highest-quality companies, including those with the best record of profits,” reports Bloomberg.

Quality Advantage

Historically, the small-cap/value combination has been rewarding, but it took a big hit when value languished during the recently deceased bull market. The tendency of factor leadership to change from year to year underscores PSC’s utility: with the Principal ETF’s multi-factor approach, investors don’t incur the burden of factor timing.

These days, however, PSC’s quality lean is proving meaningful for investors.

“Part of the reason quality wins so much is just over the long-run, earnings power drives stock prices and speculative juice doesn’t last long,” Bloomberg reports, citing Leuthold’s Scott Opal. “Eventually we’re going to roll into a period where profits matter, growth matters and maybe companies losing money quarter after quarter won’t seem as exciting as they are today — that’s when small-cap investors may flip back to the quality firms.”

That’s important because smaller companies often sport higher leverage and are more rate-sensitive than their large-cap counterparts. Bolstering the case for PSC are improving small-cap earnings revisions, confirming the group has some earnings momentum.

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.