Small-cap stocks and the corresponding exchange traded funds have recently been outpacing their large-cap counterparts prompting some market observers to speculate that smaller stocks could be in for a lengthy period of out-performance.
Some fundamentally-weighted small-cap ETFs could deliver even more impressive returns as more investors revisit the small-cap category. That group of funds could include products such as the PowerShares DWA SmallCap Momentum Portfolio (NasdaqGM: DWAS).
DWAS follows the popular Dorsey, Wright & Associates proprietary selection methodology that is designed to identify small-cap firms with positive relative strength characteristics in an attempt to follow companies with strong forward momentum. The ETF follows the Dorsey Wright SmallCap Technical Leaders Index.
Various data points suggest small-caps have momentum in the current environment. Favorable fundamental factors include the recent U.S. tax cuts.
“In the three years ending December 2017, the companies in the S&P SmallCap 600 Index had an average effective tax rate 4.3% higher than the S&P 500 Index,” according to Invesco. “Investors looking for stocks that may experience improved profitability due to US tax reform have turned to the small-cap sector.”
Favorable Outlook for Small Caps
Small-caps are focused on the domestic economy and have less direct exposure to global geopolitical uncertainty and currency risks, as opposed to large-cap companies that have an international footprint, which may be affected by overseas risks and a strengthening U.S. dollar. Additionally, small-cap earnings estimates are improving.
“Earnings estimate revisions have been strongest in the small-cap sector. Forward earnings estimates for the S&P SmallCap 600 Index have risen by more than 28% compared to 18.7% for the S&P 500 Index over the past six months,” according to Invesco.
DWAS holds 200 stocks and allocates over 30% of its weight to healthcare names. The financial services and industrial sectors combine for over 34% of the ETF’s roster.
Importantly, small-cap valuations are not stretched, a potentially positive sign for an asset class that often trades at a premium to large-caps.
“Some see better value in small caps as the price-to-earnings (P/E) ratio has compressed on the S&P SmallCap 600 Index, suggesting that small caps have cheapened in recent years. On a forward earnings basis, the S&P SmallCap 600 Index is currently trading at 20.1 compared to 17.0 for the S&P 500 Index. The ratio of 1.18 is down from a peak of over 1.33 in July 2009,” according to Invesco data.
Meanwhile, the iShares Russell 2000 ETF (NYSEArca: IWM), which tracks the benchmark Russell 2000 Index, is up more than 6% over the past month, outperforming major large-cap indexes along the way.
For more information on small-capitalization stocks, visit our small-cap category.