IWN: Small-Cap Value ETF; High-Risk High-Reward Reopening Play

Summary

• IWN is a U.S. small-cap value index ETF.
• Small-cap value stocks are relatively cheap and could outperform in the coming months.
• Risks abound.
• This idea was discussed in more depth with members of my private investing community, CEF/ETF Income Laboratory. Learn More »

Photo by syahrir maulana/iStock via Getty Images

The iShares Russell 2000 Value ETF (NYSEARCA:IWN) is a U.S. small-cap value index ETF investing in these same securities. Small-cap value stocks are undervalued relative to their peers and are likely to outperform in the coming years. On the other hand, small-cap value stocks are generally quite risky, hence their cheap valuations, and yield very little.

IWN is a classic high-risk high-reward investment opportunity, but one that should outperform in the coming months, in my opinion at least.

As the fund is quite risky, it is only appropriate for less risk-averse investors. More risk-averse investors, especially those looking for safe, dependable dividends, should look elsewhere.

Fund Basics

• Sponsor: BlackRock
• Underlying Index: Russell 2000 Value Index
• Expense Ratio: 0.24%
• Dividend Yield: 1.27%
• Total Returns CAGR (Inception): 8.84%

Fund Overview

IWN is an index ETF investing in small-cap value stocks. The fund tracks the Russell 2000 Value Index, an index of these same securities.

The index starts by selecting all U.S. equities that meet a very basic set of criteria, centered on price, market capitalization, trading, and voting rights requirements. Applicable stocks are then ranked according to their market cap, and the index selects/invests in the companies ranked #1,001-#3,000, which effectively comprise the U.S. small-cap equity subsector. FTSE provides investors with the following table summarizing the situation:

(Source: FTSE)

The index then selects all applicable value stocks out of these 2000 stocks. Stocks are ranked according to their price to book ratio, expected growth, and past growth. Value stocks are those ranked the lowest, with the least growth and smallest price to book ratios. Weights take into consideration valuation, with lower valuations equaling greater weights. This is a simplified account of how the system works. There are quite a few extra, unnecessarily complex kinks and calculations too, but these don't seem terribly important, in my opinion at least.

IWN's index seems to work, with the fund investing in smaller, more competitively valued companies. The difference with broader equity index funds is stark:

(Source: ETF.com)

From the above, and taking into consideration the fund's index, it seems quite clear that IWN is a perfect fund for investors looking for small-cap value stocks, exactly what you would expect from its name. These securities differ quite markedly from the broader equities market, especially so when compared to some of the most popular mega-cap names or indexes. This isn't an S&P 500 or Nasdaq-100 index fund. Let's have a look at some of the characteristics of these securities.

Small-Cap Value Stocks Analysis

Everything you need to know about U.S. small-cap value stocks is in the following graph:

(Source: J.P. Morgan Guide to the Markets)

As can be seen above, in the bottom right corner, small-cap value stocks are currently significantly undervalued, some might say less overvalued, relative to all other equity sizes / styles.

The word relative is key.

Value stocks are always cheaper than growth stocks, but they are much cheaper now than in the past. Growth stocks are always expensive, but they are much more expensive now than in the past. The difference is quite stark.

(Source: J.P. Morgan Guide to the Markets)

Small-cap value stocks are only trading at a PE of 15, only slightly higher than their 20-year average of 13-14. Taking into consideration the earnings hit brought by the ongoing coronavirus pandemic, the continued economic recovery / reopening, and low interest rates, small-cap value stocks seem slightly undervalued, perhaps fairly valued.

The average large-cap stock is trading at a 42% premium, with small and medium-cap growth stocks trading at double their historical average valuation. These are excessive premiums and, in my opinion, wholly unjustified and unsustainable. Losses are possible, lackluster returns even likelier, while sustained outperformance or double-digit gains seem all but impossible. Large-cap equities have performed exceedingly well this past decade, the next seems much less rosy.

Seems clear that small-cap value stocks provide investors with strong value, and are one of the few stock subdivisions / styles / niches with the possibility of strong returns moving forward.

In practice, and taking into consideration equity market movements these past few months, small-cap value returns are contingent on economic conditions. Expect strong returns as the pandemic subsides and economic conditions improve, significant losses if these worsen. As an example, IWN experienced significant gains this past November, when positive results for Pfizer's (PFE) coronavirus vaccine was first announced:

Data by YCharts

I expect further gains as mass vaccinations continue, and as the economy more comprehensively reopens later in the year.

Notwithstanding the above, there are two issues or negatives with small-cap value stocks.

First, is the fact that these securities have significantly underperformed for years. Small-cap value stocks have the worst performance out of all major investment styles for the past decade, and the situation is not particularly close.

(Source: J.P. Morgan Guide to the Markets)

The same is true for IWN for the past decade:

Data by YCharts

Small-cap value stocks have simply underperformed for years, a significant negative for IWN and its shareholders. As mentioned previously, I do believe that future returns will likely be higher, but the past has been quite bad, and that is something for investors to consider.

On the other hand, fund returns have been beyond outstanding since inception:

Data by YCharts

At the same time, it's important to remember that growth outperformance was almost exclusively due to valuation expansion. Underlying earnings growth was strong, but not strong enough to prevent valuation multiples to almost double.

The second issue with small-cap value stocks is that these companies are significantly riskier than average. Small companies generally have weaker balance sheets and less diversified revenue streams than larger ones, and so are more exposed to broader economic conditions, and suffer greater losses during downturns. Value stocks are also generally riskier and of lower quality: they wouldn't be trading at low prices and valuations otherwise. Small-cap value stocks are, understandably, the worst of the bunch, combining the negatives of both small-cap and value companies.

The best example of the above is one of IWN's largest holding: GameStop (GME). GME is best-known for its wild gyrations during the year, but it is also a struggling brick-and-mortar retailer in the online-focused video gaming industry. The company has seen plummeting revenues and earnings for years, massive losses since at least 2019, hemorrhaged hundreds of millions in cash during 2020, and doesn't generate enough in cash-flows to service its debt load. All relevant financial metrics have seen double-digit, if not triple-digit, reductions for the past five years or so:

Data by YCharts

A turnaround is possible, if perhaps not all that likely. It also seems possible that the market was being excessively bearish about the company's prospects in prior years. GME traded at a 0.10x price to sales ratio for about a year, and with a 0.50x price to book ratio for a couple of months, two excessively low figures. In any case, and regardless of the merits and drawbacks of GME as a company, the stock is incredibly risky, and could plausibly go to zero. All stocks are risky, but stocks like GME even more so.

IWN mostly invests in low quality, risky stocks like GME:

(Source: ETF.com)

Due to the above, IWN is an incredibly risky investment. The fund tends to underperform during downturns, as was the case during the start of the ongoing coronavirus pandemic:

Data by YCharts

Finally, IWN's dividend yield of 1.27% is slightly lower than that of other broad-based equity index funds. It is a small difference, but it does mean that the fund is not a worthwhile income vehicle.

Data by YCharts

In my opinion, due to IWN's high level of risk and volatility, and due to the possibility of sizable losses during future downturns, the fund is an inappropriate investment for more risk-averse income investors or retirees.

Conclusion

In my opinion, IWN is a classic high-risk high-reward investment opportunity, but one that is looking reasonably attractive at current prices and valuations. Investors should expect strong returns as economic conditions stabilize, but losses should mount if these worsen. I'm quite bullish about the fund, but risks abound, and it is an inappropriate investment for more risk-averse investors.

Analyst’s Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.