Small Cap ETFs Are Dangerous Right Now - Here’s A Better Way To Invest In Small Caps

March 26, 2018

Small Cap ETFs Are Dangerous Right Now – Here’s A Better Way To Invest In Small Caps

  • Small cap U.S. stocks have outperformed everything in the last 9 years and are up 500%.
  • We’ll look at the fundamentals to see whether they are overvalued.
  • You always have to keep an eye on small caps. The current price doesn’t matter, you’ll see why.



Introduction

We know that stocks are generally overvalued and that small caps usually outperform other stock market segments, albeit with more volatility. Now, there has been a lot of talk about how even small caps are overvalued and are a part of the stock market to definitely avoid even if it’s tempting to search for opportunities where Wall Street is renowned for missing them.

Let’s dig into the U.S. small cap environment to see what’s going on. I’ll start by taking a look at the iShares Core S&P Small Cap ETF (IJR) which tracks the S&P 600 small cap index.

Small Cap Performance

Small caps usually outperform and their performance over the last 18 years has been nothing short of stellar. $10k invested in IJR in 2000 would now be north of $50k not including any dividends, while the S&P 500 is up ‘only’ 83%. A 500% performance leads many to believe the small cap environment is hugely overvalued.

Figure 1: Small Cap ETF since 2000. Source: iShares.

What’s even scarier is that the returns have been achieved in the last 9 years.

The price to earnings ratio of the ETF is 22.48 and the price to book ratio is 2.19. Both are below S&P 500 levels of 25 and 3.32, respectively. The dividend yield is 1.26% which is below the S&P 500 yield of 1.81%, but still not much of a difference.

A look in more detail will show that the Small Cap ETF has no company with a weight of more than 0.6% which is amazing diversification (Note: the top 10 S&P 500 companies make up 20% of the index).

Figure 2: Small Cap ETF composition. Source: iShares.



Stocks may not be overvalued, but there is a huge risk for small caps.

The market cap of the IJR ETF is $37 billion, and that isn’t the only small cap ETF out there. The S&P 600 small cap index includes companies with market caps between $400 million and $1.8 billion with a median of $1.1 billion which makes the total market cap of the index is around $660 billion. This means that just one ETF has 5.7% of the index.

As lots of small caps don’t have much liquidity, they are mostly privately owned with small floats, so a rush to sell small caps ETFs would wreak havoc.

Fortunately, the other small cap ETFs aren’t as big as the two iShares ones, but it still all cumulates.

Let’s look at the iShares Russell 2000 ETF to see whether the situation is different there. Again, the PE ratio is 20.19 with the price to book ratio at 2.27. The sector also looks well diversified and no holding has more than 0.6%.

Figure 3: Russell 2000 ETF diversification. Source: iShares.

The total value of the index is $44 billion and with a weighted average market cap of $1.3 billion for constituents. It provides less liquidity risk than the S&P 600 small cap ETF, but still is a risky exposure.

So Should You Invest In Small Caps?

Now, when I see a 500% jump over 9 years, I get scared and that’s why I personally wouldn’t invest in small cap ETFs. The liquidity risks are simply too high and we know that small caps usually deserve a big premium due to the low liquidity and higher volatility in market turmoil.

From that perspective, small caps are overvalued. If we go back to the charts above, the PE ratio of small cap stocks in 2000 was around 10 while of the S&P 500 was around 35 which shows what kind of premium small caps usually carry. So I would say small caps are overvalued from a long term premium perspective but they will probably still beat the S&P 500 due to higher earnings. However, there will be higher volatility both in earnings and in stock prices as always.



The key with investing in small caps is to look at the business. When you find a great business, the price you pay for it simply doesn’t matter. If you had bought Walmart (NYSE: WMT) at the IPO in 1970, your returns would have been spectacular as the current dividend on $1,000 invested would be around $84k. That’s just the dividend. However, you would have been in the red for most of the 1970s as WMT’s stock was down 75% by 1974.

The problem is that you can never know how a small cap will perform but what you can know is that if you find a great business, you’ll do fine no matter what. I bet you that there are a few great undiscovered businesses in the Russell 2000 that will be amazing investments over the next 30 years.

Figure 4: WMT’s stock in the 1970s. Source: Author’s data.

So the thing to do is to go through the whole Russell 2000 index and find the best few investments. Nobody said getting rich is a walk in the park.

On a more serious note, small caps should be a part of every portfolio but try to find those that best fit your financial needs, risks, and goals. Buying or holding the ETF now is extremely risky for a marginally higher return than what the S&P 500 offers.



By Sven Carlin Investiv Daily Small Caps Share: