XSVM: Wait And See Approach Is Warranted For Low-Valuation Small-Cap ETF (NYSEARCA:XSVM) #NewsETFs

The Invesco S&P SmallCap Value with Momentum ETF (NYSEARCA:XSVM) has been around since 2005, as a fund offering exposure to smaller capitalization companies. This fund follows two core investment themes. It primarily has a bias toward stocks trading at low valuations, while also screening stocks with persistent relative performance.

This fund has done relatively well over the years, outperforming small-cap stock indexes, despite some weakness year to date. In addition, XSVM’s valuations are low compared to those benchmarks and other small-cap ETFs as well, driven by its allocation to industries such as insurers, banks, and mortgage finance, alongside a selective approach to technology and healthcare sectors. However, while a slowing economy poses a challenging environment for smaller capitalization companies for the time being, XSVM is a fund worth keeping on the watch list as an interesting play on economic recovery once the effects of the coming easing cycle unfold.

ETF Description & Highlights

XSVM is an exchange-traded fund offering exposure to U.S. smaller capitalization companies that exhibit low valuations and have had better recent performance relative to other securities.

This fund tracks the S&P SmallCap 600 High Momentum Value Index, which is composed of 120 stocks with the best value and momentum scores from the S&P SmallCap 600 index. As a point of note, this index is a subset of 600 smaller capitalization companies, which complements a suite of three benchmark indexes, including the S&P 500 and the S&P MidCap 400 indexes. Combined, these three indexes correspond to the constituents of the S&P Composite 1500 index, representing nearly 90% of the U.S. market capitalization.

Back to the S&P SmallCap 600 High Momentum Value Index, it is constructed based on an initial selection of 240 companies with the best value scores, calculated using three measures: book value-to-price ratio, trailing twelve-month earnings per share divided by stock price, and trailing twelve-month sales per share divided by stock price. The index provider then selects those 120 companies with the highest momentum scores, measured by the percentage change in the stock’s price in the last twelve months, excluding the previous month, adjusted to the volatility of each stock. Finally, each constituent is weighted in the index according to its value score.

As of August 22, 2024, XSVM is composed of 118 constituents, with $841.2 million in AUM and an average market cap of $2.0 billion. As a momentum fund, its stock rotation tends to be relatively high, as evidenced by its reported turnover of 75% versus 25% in the S&P SmallCap index, represented in this analysis by the iShares Core S&P Small-Cap ETF (IJR).

XSVM’s top holdings are Kelly Services (1.7%), Bread Financial (1.6%), Kohl’s (1.6%), StoneX (1.6%), Group 1 Automotive (1.5%), Par Pacific (1.4%), Titan International (1.4%), Jackson Financial (1.4%), Andersons (1.3%), and EZCORP Inc (1.3%), represent 15% of total assets in a diversified allocation strategy, as the top holding corresponds to only 1.7% of the fund, with a predominance of financial services, industrial and consumer discretionary sectors.

Below is a table with a peer group of small-cap ETFs adopting strategies toward value that will serve as a benchmark for XSVM in this analysis. The largest one is VBR, a fund with relevant exposure to mid-caps as well. The other five ETFs have allocations concentrated in small and micro caps, with a much larger number of holdings compared to XSVM, such as the IWN, which adopts the Russell 2000 index as the starting universe of stocks. The closest fund to XSVM in terms of the number of holdings is IJS, with 463 stocks in its composition, also using the S&P SmallCap 600 index as the benchmark.

From a sector allocation perspective, XSVM’s largest allocation is to the Financial Services sector, with 29.3% of total equities, followed by Consumer Discretionary with 25.5%, Industrials 14.2%, Energy 9.0%, Basic Materials 7.5%, Real Estate 3.9%, Technology 3.9%, Consumer Staples 3.5%, Healthcare 1.9%, and Communication Services 1.3%. Relative to the S&P 600 index, XSVM is significantly overweight in Financial Services (+11.8%), Consumer Discretionary (+11.2%), and Energy (+4.4%), but underweight in Technology (-9.6%), Healthcare (-8.8%), and Real Estate (-5.1%). XSVM’s overweight allocation to financial services is led by holdings in insurers (Lincoln National, Assured Guaranty), regional banks (First Hawaiian, Ameris Bancorp, and Axos), and players in the mortgage industry like Mr Copper and Radian, while allocation to the discretionary sector is marked by holdings in Homebuilders Meritage, Tri Pointe, M/I Homes, and in automotive retailers Asbury and Group 1.

Relative to the peer group of small-cap value ETFs, XSVM is primarily overweight in consumer discretionary and, to a lesser extent, financial service, as value ETFs tend to hold heavier positions in financials, given the generally lower valuations seen in this sector.

Low Valuations, Relatively High Growth Profile

XSVM’s holdings in low valuation areas such as insurers, banks, and mortgage finance have led to average valuations nearly 30% lower than the S&P SmallCap 600 index, and even compared to another small-cap benchmark, the Russel 2000 index, with both having price/earnings ratios of roughly 16x, which is significantly higher than 11.4x for XSVM. XSVM’s valuation is also lower than other small-cap value ETFs, as the peer group’s price/earnings average is roughly 13.6, translating into a 16% premium over XSVM.

This reflects XSVM’s low and selective exposure to technology and healthcare, as a number of its holdings in these sectors trade at low multiples, like the manufacturing solutions provider Sanmina (13.3x), the electronic manufacturer TTM Technologies (12.9x) and the healthcare distributor Owens & Minor (9.9x), as opposed to many other names in these sectors with valuations above 20x, such as the electronic equipment manufacturer Badger Meter (47.7x) or health care supplier Merit Medical (27.7x) where XSVM holds no positions.

Another positive aspect of XSVM’s holdings is the higher average growth profile compared to small-cap indexes and the peer group of small-cap value ETFs, as the small-cap category as a whole presents relatively subdued growth compared to larger capitalization benchmarks like the S&P 500 index, which for instance exhibits historical earnings growth of nearly 7%.

Outperformance In the Long Run, Weakness To Date

In an environment where large-cap benchmarks, such as the S&P 500 index, have done much better than the overall market over the past years, the performance analysis for small caps has been more about relative returns within the group than anything else. In this context, XSVM’s total returns have been reasonably good in the long run, as this fund has outperformed small-cap benchmarks such as the S&P SmallCap 600 and the Russell 2000 indexes, as well as the peer group of small-cap value ETFs. Meanwhile, XSVM has shown higher volatility measures, such as beta and standard deviation, within the small-cap category, but it is not a major issue per se, as XSVM is also a momentum fund, which is expected to prompt the fund to hold shares of best-performing stocks, probably with larger price swings compare to the benchmarks.

Perhaps a bit concerning is XSVM’s returns year to date, as its underperformance in the past weeks exacerbated what has already been a weak year on a relative basis for the fund.

Looking ahead, the outlook for smaller capitalization companies will be largely tied to two main factors, in my view. The first one is related to the interest rate path, as lower rates are expected to reduce borrowing costs, which is a crucial issue for earnings in the small-cap segment. The second point is earnings growth, and this seems a more complex issue now, as the current slowing economy is not the best setup to support growth on the earnings front.

This mixed environment with subdued growth expectations is likely to limit stock price gains in small caps in the near future, which suggests a more conservative stance on small-cap stocks and funds like XSVM. Nonetheless, despite the somewhat challenging short-term outlook, I view XSVM as a fund to keep on the watch list, given its overall positive track record over the years, combined with a portfolio offering lower valuations and above-average growth that is likely to bode well for XSVM’s future performance once the macroeconomic conditions improve, and we can see a more favorable environment for growth.