The Intelligent Investor

Danger Zone: Small Cap Value ETFs & Funds

Small Cap Value ETFs and mutual funds are in the Danger Zone this week. The Small Cap Value style ranked last out of twelve fund styles in my Style Rankings For ETFs and Mutual Funds report.

Check out this week’s Danger Zone interview with Chuck Jaffe of Money Life and MarketWatch.com.

Small Cap Value ETFs and mutual funds are in the Danger Zone this week. The Small Cap Value style ranked last out of twelve fund styles in my Style Rankings For ETFs and Mutual Funds report.

Of the 277 Small Cap Value ETFs and mutual funds under our coverage, 266 earn a Dangerous-or-worse rating. No ETF or mutual fund in the Small Cap Value style earns better than a Neutral rating.

Figure 1 shows the breakdown of stocks, mutual funds, and ETFs in the Small Cap Value style. 793 out of the 2,205 stocks held by Small Cap Value funds earn a Neutral-or-better rating.

Figure 1: Small Cap Value Style Landscape For ETFs, Mutual Funds & Stocks

Fig1

Sources: New Constructs, LLC and company filings

Neutral-or-better stocks make up 42% of the market cap in the Small Cap Value style, but only 7% of ETFs and 4% of mutual funds in the style even manage to earn a Neutral rating. Investors should have better options from which to choose in this style.

To make matters worse, investors are doing a poor job of choosing between the fairly meager options in the Small Cap Value style. iShares Enhanced U.S. Small-Cap ETF (IESM) is my top rated ETF in the style, but it has only $3 million in total assets. Similarly, Bernzott US Small Cap Value Fund (BSCVX) is my top rated Small Cap Value mutual fund but has only $25 million in assets. Both IESM and BSCVX are relatively new funds, so it appears investors are shying away from them and sticking with more established ETFs and mutual funds.

Even though the advice “past performance is not a guarantee of future returns” gets repeated again and again, investors still gravitate towards funds with a strong history of performance. Unfortunately, that means that investors in the Small Cap Value style are missing out on funds with superior holdings simply because those funds don’t yet have established track records.

Normally investors at least do a good job of avoiding funds with high costs, but even that is not the case in the Small Cap Value style. American Century Capital Portfolios: Small Cap Value Fund (ACSCX) is my worst-rated mutual fund in the Small Cap Value Style and charges total annual costs of 5.26%, the highest in the entire style. Despite its poor holdings and high costs, ACSCX has over $2.2 billion in assets.

Multi-Color Corporation (LABL) is one of my least favorite stocks held by ACSCX and earns my Very Dangerous rating. LABL has followed the strategy of many companies in fragmented industries and attempted to grow profits primarily through acquisition.. A spate of acquisitions between 2011 and 2013 helped LABL nearly double its reported net income. However, LABL’s return on invested capital (ROIC) declined from 9% to 7% over that same time frame, which suggests these acquisitions have not truly helped LABL’s cash flows.

Investors seem to be dupes by the high-low fallacy of LABL’s EPS growth as the stock has jumped over 52% so far this year. With this recent surge, LABL has become dangerously overvalued. LABL’s current valuation of ~$36.50/share implies that the company will grow after tax profit (NOPAT) by 20% compounded annually for eight years. The label industry is not exactly a high growth business, so I don’t see how LABL can hope to achieve that kind of growth. With ~$450 million in adjusted total debt and no excess cash, LABL does not have the resources to fund new acquisitions.

Investors in ACSCX have benefited from LABL’s run-up this year, but now the stock has overshot its fundamentals and looks primed for a pullback. Investors should not be willing to pay ACSCX such high fees for past performance when the fund’s current holdings are so poor.

Investors would be much better served with BSCVX, which charges total annual costs of only 1.1% and earns my Neutral portfolio management rating. BSCVX allocates roughly 25% of its assets to Attractive rated stocks.

One of my favorite stocks held by BSCVX is International Game Technology (IGT). Over the past three years, IGT has increased its ROIC from 7% to 10% and widened its NOPAT margin from 13% to 18%. The casino gaming developer recently announced a deal to supply Caesars Entertainment Corp (CZR) with 7,000 video poker terminals. Despite these positive signs, IGT has a surprisingly cheap valuation. Third quarter results that missed analyst expectations sent the stock plunging 10% last week, which makes the stock an even more enticing value for investors. At its current stock price of ~$17/share, IGT has a price to economic book value ration of only 1.2, which implies that the company will not grow NOPAT by more than 20% for the remainder of its corporate life. Given IGT’s expanding margins and the expected growth in the casino gaming industry, IGT should exceed these modest expectations.

It’s a shame that more funds aren’t allocating to quality stocks like IGT. No Small Cap Value ETF or mutual fund besides BSCVX allocates more than 2% to IGT. On the other hand, 12 mutual funds in the style allocate at least 2% of their assets to LABL. Investors deserve better stock picking than Small Cap Value ETFs and mutual funds are currently providing.

Sam McBride contributed to this article

Disclosure: David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, or theme.

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Trainer brings insight and transparency to research on stocks, ETFs and mutual funds.
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