Small-capitalization stocks, especially those leaning toward the value style, and related ETFs have been among the worst-performing broader segments of the U.S. markets, but they could begin to outperform as the economy recovers from the coronavirus lockdowns.
The Principal U.S. Small-Cap Multi-Factor Index ETF (NASDAQ: PSC) is higher by more than 50% in the second quarter, putting it more than 800 basis points ahead of the Russell 2000 Index, while potentially signaling the small-cap value combination is on the mend.
“Small value stocks are today’s barometer. The main concern entering the New Millennium was whether technology stocks had become too richly priced,” writes Morningstar’s John Rekenthaler. “Approaching the global financial crisis, the question was whether all banks would implode. For those questions, small value stocks could offer few answers. However, their fortunes are irrevocably linked with today’s key questions. Will the recession be brief, or will it persist? When it does conclude, will the economy look as it did before?”
PSC Matters Now
Looking ahead, small-caps could outperform as revenue picks up, and revenue typically has a proportionally greater effect on operating income for smaller companies.
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.
A more sanguine environment coupled with a credible economy could fan upside for small-cap value funds such as PSC.
“Besides a rapid recovery, small value companies seek a return to normalcy,” notes Rekenthaler. “Some forecast that the experience with COVID-19 will forever alter American habits, as high-tech applications replace brick-and-mortar locations. Shopping will continue to move online; office spaces will become virtual; business travel will be curtailed.”
In today’s market that’s brimming with uncertainty surrounding the coronavirus outbreak, it can also help investors to use factor investing to filter out the best opportunities. Nowadays, the focus has been quality and value amid the discounted equities, but investors also shouldn’t miss out on other factors like growth or momentum, which are not excluded from PSC, making it a potentially more lucrative way of capturing small-cap value compared to legacy offerings in this category.
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.