Small-Cap ETF RWJ Will Likely Outperform SPY

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Investing in small-cap ETFs like Invesco S&P SmallCap 600 Revenue ETF (NYSEARCA:RWJ) might seem counterintuitive in a recession – after all, larger companies in the SPDR S&P 500 Trust ETF (SPY) have more resources with which to weather economic turmoil. Downturns are periods of uncertainty, and investors often flock to the apparent safety of blue-chip stocks. RWJ is based on the S&P SmallCap 600, but with stocks reweighted by revenue.

Investors would be mistaken to overlook small-cap ETFs like RWJ, as they’ve outperformed large caps following the last nine recessions. And in 2022, SPY returned -18% while RWJ returned -11%. RWJ is a much newer ETF than SPY, but we can look more broadly to the past performance of small-cap stocks vs. large-cap stocks.

On average, small-cap stocks return 34% one year after a recession, while large caps generate an 18% return. While small caps have greater risk associated with them, they have significant upside potential in bear markets. RWJ is an easy way to gain exposure to these small-cap assets with a low expense ratio of 0.39%. With $1.21 billion in assets under management (AUM), RWJ is also significantly larger and more liquid than its small-cap ETF peers such as Invesco S&P SmallCap 600 Equal Weight ETF (EWSC), which has just $56.49 million in AUM.

Even barring a recession (which Bloomberg analysts posit has a 100% chance of hitting in 2023), today’s macroeconomic conditions are favorable for small caps. Historically, rising interest rates have favored small caps, with the Russell 2000 outperforming the S&P 500 as 10-year yields increase. Small-cap ETFs have experienced increased inflows as investors look to capitalize on the potential for higher returns.

Other small-cap ETFs like the Vanguard Small-Cap Value ETF (VBR), the Schwab U.S. Small-Cap ETF (SCHA), and the Vanguard Small Cap Growth ETF (VBK) provide more ways to gain exposure to this market, while private markets can provide even greater upside potential. Accredited investors can access private small-cap stocks through platforms like Gridline, which gives investors access to alternative investments such as private market small caps with low capital minimums and fees. There are a couple key reasons for small-cap outperformance, including greater maneuverability and less competition in niche markets. Let’s take a closer look at these advantages.

RWJ component firms are more nimble

The “small firm effect” has been studied for decades. Looking at 40 years of data, researcher Rolf Banz published a now famous paper in 1981 titled “The Relationship Between Return and Market Value of Common Stocks.” He concluded that small-cap stocks had higher returns than large-cap stocks.

The next 40 years reinforced this conclusion, with small caps outperforming in recessions and also during times of strong economic growth. This could be due to their greater capacity for risk-taking and the fact that they are more nimble. Small companies can take advantage of new opportunities and adapt quickly to changes in the market.

Consider, for instance, the case of Netflix (NFLX) and Blockbuster. Netflix saw the potential in streaming services before its larger competitor and made a strategic move, while Blockbuster was slow to respond. The Great Recession saw a dramatic crash in Blockbuster’s stock, culminating in their bankruptcy, while Netflix’s value surged.

The Great Recession also gave birth to the RWJ ETF, which was launched in February 2008. As we’ve seen, RWJ has outperformed SPY in the last five years – and particularly in 2022. RWJ’s top 10 holdings reflect the ETF’s diversity across sectors:

• World Fuel Services Corp. (INT)
• United Natural Foods Inc. (UNFI)
• Group 1 Automotive Inc. (GPI)
• Asbury Automotive Group Inc. (ABG)
• Andersons Inc. (ANDE)
• Community Health Systems Inc. (CYH)
• Sonic Automotive Inc. Class A (SAH)
• Bed Bath & Beyond Inc. (BBBY)
• Cushman & Wakefield Plc (CWK)
• Insight Enterprises Inc. (NSIT)

RWJ’s largest holdings are in consumer cyclical and industrial stocks, followed by consumer defensive, energy, technology, financial, healthcare, basic material, and other sectors. Its largest sector, consumer cyclical, makes up 24.9% of the ETF, with just over 8% in technology. By way of comparison, 24.5% of SPY is composed of technology stocks. Some macro analysts expect consumer cyclical margins to even see margin expansion in 2023, while tech margins will remain under pressure due to slowing growth and continued inflation.

RWJ firms are able to win in niche markets

The same small firm effect that allows for greater risk-taking also applies to the competitive landscape. While large companies like those in SPY will naturally dominate major industries – using consolidation, economies of scale, and other tactics – smaller companies like those in RWJ are able to find and compete in niche markets.

As an Alliance Bernstein report highlights, General Mills (GIS) warned in 2022 that its operating profit was under pressure, and that its iconic brands – like Cheerios and Häagen-Dazs – were no longer immune to competition from smaller players. In a high-inflation environment, brand-name products no longer have the same competitive edge. Consumers are increasingly willing to purchase generic products, as well as other alternatives from small-cap companies.

Small-cap stocks become even more attractive during inflationary periods, as these companies can benefit from lower prices and higher demand. This outperformance is captured even more prominently in private markets, as companies are staying private for longer and take-private deals are near all-time highs. Of course, there’s no guarantee of any outperformance, but with the right due diligence investors can find a number of attractive opportunities.

RWJ is still undervalued

Despite the recent uptick in the markets, small caps remain undervalued relative to their large-cap peers. As of Feb. 4, 2023, RWJ is trading at a price/earnings ratio of 12.85x, compared to SPY’s 22.11x. In other words, SPY’s P/E ratio is 72% higher than that of RWJ.

Small caps are also trading at a discount to their historical averages. While SPY is above its 10-year average forward P/E today, RWJ is still trading below its average. The potential causes of this discount are many.

Small-cap stocks are less liquid than their large-cap counterparts, making it difficult for institutional investors to trade large positions in a timely manner. Small-cap stocks are also more volatile and have less analyst coverage, meaning investors can find good opportunities without the same level of competition.

Another factor is the recent rally in tech stocks. While the S&P 500 has been driven largely by tech, small-caps have been left behind. This has created an opportunity for value investors to scoop up smaller stocks at discounted prices. Furthermore, the current economic outlook is driving investors to look past the short term and focus on longer-term value.

Small-cap stocks are primed to be the beneficiaries of this shift, as their long-term growth prospects are often more attractive than those of larger companies. And as we’ve seen, small-cap stocks tend to outperform in periods of economic recovery, providing investors with an opportunity to take advantage of a potential bounce back in the markets.

Falling inflation favors RWJ

U.S. inflation reached near double-digit levels in 2022, but it has since fallen to 6.5%. Golden Sachs Asset Management reports that since 1950, small-cap stocks have seen a median return of 21% during the 20 years when starting inflation was above 3% and ended lower. The median return for large caps during the same period was just 5%.

Small-caps have traditionally outperformed in recessions and when the Federal Reserve stops raising interest rates. If inflation continues to ease or if the economy slips into recession, investors might have the opportunity to benefit from such performance. Again, the potential causes for this are varied.

Small caps have a higher dividend yield and a lower P/E ratio than large caps, making them more attractive in a lower-inflation environment. Small caps also tend to be more closely linked to domestic markets, which can benefit from lower inflation because it reduces costs for businesses. This can lead to higher profits, which can lead to higher stock prices.

Furthermore, falling inflation can lead to lower interest rates, which can make it easier for small-cap companies to borrow money and expand. This might seem to go against the data shared above, showing that the Russell 2000 tends to outperform when 10-year Treasury yields are rising. However, this outperformance is far less pronounced than the outperformance seen when inflation is falling. In the long run, lower interest rates can support small-cap stock prices.

Risks of investing in RWJ

The thesis behind RWJ and small-cap stocks is an attractive one, with small caps historically outperforming after recessions and when inflation is falling, along with the potential to benefit from nimble risk-taking and niche competition. However, there are still a number of risks to consider before investing in RWJ. The key risk is RWJ’s concentration in consumer cyclical stocks.

A bullish thesis in 2023 relies on a relatively shallow recession and a quick economic recovery. If the recession is deeper and longer-lasting than expected, consumer cyclical stocks will be hit hard. Of course, this doesn’t negate the potential for small caps to outperform in the long run, but it could lead to a period of underperformance in the short term.

Another risk is that inflation hasn’t actually peaked. If inflation rebounds, then the historical data suggesting small caps will outperform might not hold true. Additionally, small-cap stocks are more volatile than large-cap stocks, so there is greater risk associated with them.

Still, a host of factors has made RWJ and other small-caps attractive in the current market, and there are plenty of opportunities for investors to take advantage of. With the right research, investors can find attractive small-cap stocks in both public and private markets and reap the rewards of potential outperformance.