Why the Time Is Now for Small-Cap and Micro-Cap ETFs

by Max Isaacman, Minyanville staff writer
Pundits have cautioned against a possible bond market bubble that could lead to a bond market collapse for over four years now. There has been less money going into bonds and a concomitant increase of money flowing into stocks, ETFs, and equity mutual funds, and this is in the face of the government doing much that should scare off investors. We don’t know what will happen with the latest government standoff, which is the struggle over raising the debt ceiling, or with any other possible Washington standoffs, but those who wait to invest in equities until after the smoke clears may miss an opportunity, just as opportunity was lost waiting until after January 1, 2013 to invest in equities. This is especially true in the riskier asset classes, such as emerging markets, small-cap, and micro-cap. (Micro-cap stocks generally are referred to as those companies that have a market capitalization of about $50 million to $300 million.)
The small-cap and micro-cap class are the most volatile cap sizes. Investors in these classes are making a bet that the US economy will grow. Small-cap companies and micro-cap companies have a larger portion of their revenues coming from the US than mid- and large-cap companies, and they benefit more from a stronger US consumer and increased corporate spending. The S&P 500 Index (INDEXSP:.INX) companies receive almost half of their sales from foreign countries, and companies in the S&P Small-Cap 600 Index get less than 30% from foreign country sales. Small-cap companies can also get a boost from an increasing number of corporate buyouts, which will probably happen if the economy continues to improve. There are risks in small caps. If financing gets tight, small-cap companies can suffer, since their access to capital is not as great as big-cap companies. Tight financing risks are even greater in micro-cap.
A way to invest in small-cap ETFs is through sectors, rather than broad-based small cap ETFs. The PowerShares Small-Cap Technology ETF PSCT holds the same stocks as those that are in the tech sector of the S&P 600 Small-Cap index. And PSCT does not hold Apple AAPL stock, which has been a problem holding for tech ETFs, since it has declined in value. AAPL dominates many of the tech sector ETFs, and it has declined about 35% from its high over the last 52 weeks, which is the worst performance of all technology stocks in the indexes. Apple comprises about 3.5% of the S&P 500 but about 20% of the S&P 500 technology sector. The reasons for Apple’s pullback are varied. Among the concerns is that there is more competition in the tablet and mobile phone markets. Perhaps much of the selling is just profit taking. Apple now sells at a reasonable multiple, and a concern about a severe downward price pressure from here is probably not warranted.
Tech firms continue to benefit from continued changes in the industry, trends such as cloud computing, more consumer products, and consumers’ switch to mobile devices and systems. Even if the demand from consumers weakens, tech should continue to grow. Growth in the sector has softened a bit because of global economic weakness and negative news regarding Apple’s slowdown, and potential industry slowdown. Tablets, smartphones, and other devices are still good sellers. Even if the personal computer market continues to slow, and there is some question if it will, other products should take up the slack.

Micro-Cap ETFs as a High Beta Trade.

Micro-cap ETFs have outperformed the S&P 500 Index in the last year, and in shorter time periods, such as over the last three months and six month periods. Micro-caps have good price momentum and their price/earnings ratios are still reasonable, making them not appear to be overbought. Two that look attractive are the Guggenheim Wilshire Micro-Cap ETF WMCR, and the PowerShares Zacks Micro Cap Portfolio PZI.

The Guggenheim Wilshire US Micro Cap ETF has exposure to about 800 securities, and no one company makes up more than about 1.1% of assets. Financials are the largest sector at about 26% of total assets, and health care makes up about 23%. Tech has a large allocation at about 18%. WMCR has a low price/earnings multiple, at about 13 times.

PZI tracks the Zacks Micro Cap Index, and is designed to identify the micro-cap stocks with the greatest potential to outperform passive benchmark micro-cap indexes and actively managed US micro-cap strategies. Its index holds just 400 names. Financials comprise the biggest sector of the index at about 26%, and tech, industrials and consumer discretionary each comprise about 14% of total assets. PZI sells at a fairly rich earnings multiple of about 20 times.

Trading Micro-Cap ETFs.

Buying and selling stocks to keep within an index mandate is usually not a problem for ETF managers because markets are generally liquid. A problem with micro-cap ETFs is that there could be a liquidity problem in that ETF indexes usually contain stocks that have limited floats, which equates to limited liquidity in the marketplace. When an ETF sponsor has to buy and sell stocks to rebalance to keep within its models, the sponsors cannot just drop market orders. If the managers put in market orders they could drive up or down the market price, and end up buying or selling stock outside of the stock’s realistic market price.
Market liquidity in micro-cap stocks will get better if the general market continues to improve and the public’s risk appetite grows. But at times when markets are not going up, liquidity is a problem, and special handling will be necessary. The problem is mitigated somewhat by the large amount of stocks that are in the index baskets, giving diversity that is common to micro-cap ETFs.
Paul Weisbruch of Street One Financial is a liquidity provider for stocks and ETFs, and he works at making it possible for sponsors and traders to trade what are sometimes illiquid securities. Weisbruch says that small- and micro-cap ETFs are back in focus because of their potential to deliver growth. Weisbruch says, “In 2013, we have certainly noticed a pick-up in activity in small-cap sector oriented funds, such as PSCT, in addition to increasing allocations being made to the micro-cap specific names as well. This, along with an increase in activity and a lift in performance in country specific “small cap” products, such as iShares MSCI Brazil Small Cap Index ETF EWZS, shows us that investors who may have sat on the sidelines during the past few years as the equity markets have rallied are embracing higher beta segments of the market, whether they be US domestic or even foreign based small- and micro-cap equity names, via an assortment of newer and innovative ETFs.”

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