Is Growth the New Value in Smallcaps?

Debates over growth and value investing are often sidetracked by definitional disagreements as to what constitutes a growth stock and what constitutes a value stock. But if you’re investing in a growth of value ETF then the answer is simple: it’s whatever the fund says it is. And therein lies the opportunity.

In our analysis of the underlying constituents of the iShares S&P SmallCap 600 Growth (IJT) and Value (IJS) funds we found a startling fact: stocks in the growth fund are now cheaper than stocks in the value fund!

Actually IJT is only cheaper by a fraction in terms of the price-to-earnings ratio (Figure 1), but typically you’d expect value stocks to trade at a noticeable discount to growth stocks, not at a slightly premium. And at any rate most value investors are generally looking for stocks with P/E ratios in the 10-14x range, not the nearly 20x that smallcap value stocks in IJS now fetch.
Oddly enough, this is not the result of the smallcap value stocks outperforming smallcap growth stocks dramatically as is the case with large cap growth and value stocks. In fact, while smallcap value stocks did fare much better during the last recession, over the past five years—an expansionary period—IJT has done slightly better than IJS.

Rather, smallcaps in general have a dearth of “value-type” industries to begin with, and as a result the sector make-up of IJS is probably not what you’d expect from a value fund. Specifically, high-flying Consumer Discretionary stocks make up 29% of assets, versus 8% of assets in the large cap iShares S&P 500 Value fund (IVE). Meanwhile Technology stocks make up another 14% of smallcap value (verses half that amount for IVE).

On the other hand, Financials, which are typically considered value stocks because of their generally low price-to-earnings and price-to-book value ratios, account for 35% of IVE yet make up only 20% of assets in IJS. Likewise, Telecom stocks represent 7% of large cap value but are nil for smallcap value (Figure 2).

One of the criticisms I’ve made before regarding these style funds is that the methodology used to create each index isn’t particularly good at distinguishing between stocks with rapid earnings growth and those with slower earnings growth but selling at presumably cheaper valuation multiples.

That’s the case with the large cap Growth & Value funds (but that’s a topic for another day). However, stocks in the S&P SmallCap 600 Growth & Value funds have actually lived up to their names. Companies in the Growth fund (IJT) actually have grown earnings faster than stocks in the Value fund (IJS), at compound annual growth rates of 22.1%, and 15.2%, respectively, over the 2002-07E.

Whether the faster earnings growth of stocks in IJT will persist in the future is uncertain, but since they trade at essentially the same P/E as those in IJS it’s like getting potentially better growth prospects for free. Once again, our analysis shows that you can’t judge an ETF by its name.