ETF Edge - Sussing out small caps and diving back into dividends 8/19/24

Episode Date: August 19, 2024

More investors are looking at small caps but 40% of the Russell 1000 are unprofitable. One fund seeks the best of the rest. Plus, with interest rates lower, interest in dividends is higher. Hosted by Simplecast, an AdsWizz company. See pcm.adswizz.com for information about our collection and use of personal data for advertising.

The ETF Edge podcast is sponsored by InvescoQQQ. Let's rethink possibility. Investco Distributors, Inc. Welcome to ETF Edge, the podcast. If you're looking to learn the latest insights on all things, exchange, traded funds, you are in the right place. Every week we're bringing you interviews, market analysis, and breaking down what it all means for investors. I'm your host Bob Bizani. We're searching for profitable small caps and dividend-paying stocks.

Here's my conversation with Paul Bayaki. He's the chief ETF strategist for Alps. along with Mike Akins from ETF action. Paul, you heard me, 40% of the Russell 2000 unprofitable. How do you weed out those unprofitable companies? Well, what OUSM does is it takes a universe of, let's call it, 2,500 stocks after the top 500, and then starts to call them down to an investable list of companies who drive profits without excess leverage, pay dividends, grow their dividends,

and have well-covered dividends. So ROA, net debt to EBITO for the first part, profitability without excess leverage, and then things like dividend growth, dividend coverage, and dividend yield to ensure that the companies that you have are not only paying dividends, but have dividends that are well supported by fundamentals. And then finally, a low volatility screen. So the idea is quality companies that pay and grow their dividends and importantly have less volatility than their peers. So your high quality, high dividend yield. I also notice low volatility is a component here. You tend to weed out the banks, which seems to be good on this. Mike, does this make any sense?

Does weeding out unprofitable companies from the Russell like OUSM is doing here? Does that work? I mean, that's a factor, obviously. Does it lead to outperformance over the Russell? Is there evidence that weeding out unprofitable companies actually creates outperformance? So I think outperformance depends on your time, your time period, right? So I think absolutely if you take something like OUSM in today's current environment, it's led to significant outperformance over the last several years, just looking at OUSM versus the Russell 2000 or looking

at it versus the S&B 500, S&B 600, small cap securities, it's led to a significant amount of alpha. But that is, to your point, is it is a factor, right? We have been in a quality market, those funds with higher quality balance sheets. And I think what Paul did a great job explaining there was those quality factors. So before they go and look for that yield, they ensure these securities have quality factors. It's going to work. The thing you have to be careful with factors is they go in and out of favor. So if you're using factors, it's best to either blend them to a small extent and or you need to be a little bit more tactical in your approach.

But I think if you're just looking for a yield with less volatility, something like the Alps O shares U.S. Smallcap. OUSM makes a lot of sense. So, Paul, I noted before that one of the things that happens here is financials, particularly small cap banks, is a very big part of the Russell 2000. A lot of this seems to get factored out in OUSM here. I'm looking at your largest holdings. I see trade web. I see Juniper Networks.

I see Old Republic. I see New York Times. I see Primerica. Not a lot of banks in here. That's deliberate, right? I mean, that's one of the things that happens when you add these factor overlays, right? Yeah, it's not deliberate in the sense that they came up with a methodology and said, how do we exclude regional banks?

It ultimately is a product of that screening process, which you laid out, Bob. And I think to just push back a little bit on Mike's point about factors working sometimes, of factors not working sometimes. I think philosophically what OUSM does is it allows advisors and investors who have seen small caps go sideways for five years to be allocated to a category that's lagged. If you look at the Russell 2000 divided by the S&P 500 as cheap as it's been going back to the dot com era, they want to be allocated to a category, but they don't necessarily want full beta. And what OUSM has been able to do historically is avoid the drawdown. So we talked about it. on the linear side, Bob, where you've got this drawdown in COVID. OUSM doesn't participate

fully in it. You've got this massive rip your face off rally out of that COVID bottom. OUSM doesn't fully participate in that. And then at the end of 2021, small caps begin the process of drawing down again. And OUSM's drawdown avoidance has led to compounded outperformance. So in many ways, advisors, investors using ETFs have typically just defaulted to the Russell 2000 or S&P 600 and they've basically resigned themselves to the fact that by being in the Russell 2000, I'm just going to have to take the good with the bad. I'm going to have to have some good companies, some of which you listed, but I'm also going to have to take on that 40% of the index, which doesn't make money. And with OUSM, we're saying you don't have to. Right. Mike, I agree.

Sometimes these factors don't work. But overall, I've been 34 years at CNBC and I'm an original Jack Bogle disciple. I'm an original index guy from the 1990. So, I'm a true believer, but over the last 15 years, particularly since the financial crisis, I have come to really notice myself that adding a quality overlay, particularly profitability, which is a subsector of quality, does seem to make a difference here, particularly in small and mid-cap stocks. Do you notice this or am I hallucinating a little bit here? No, we've noticed it not just small and mid-caps. We've noticed it in large-cap space as well.

If you're going to compare and contrast factors, you know, quality tends to link it link well to growth, right? So most, we rate every single ETF in the marketplace. We call it derived analytics. And we score the five factors out there, size, momentum, you know, value, quality, and volatility. And if you look at quality, the firms that have, the ETFs that have the highest quality score tend to also have the highest growth score, right? So the S&P 500 growth ETF or growth index has one of the highest quality scores in our entire U.S. list of ETFs. And it's been a growth market and a big part of that growth market has been size. Right.

I think that's a big under component here. Growth companies tend to be much bigger in market capitalization. And really, if you want to boil the last 10 years down to one factor, it's been mega cap companies outperforming everything else. Yeah. Yeah, it's true. And you can get a little caught up in this small cap value has probably less profitability than small crap growth. So you can go around on this. I just want to move on a little bit here to dividend payers here because we've got Paul here runs a very interesting shop that has why has dividend ETFs in it. So we have interest rates declining and investing in dividend paying stocks in ETF seems to be getting a little bit of interest here. And Paul, you manage the Alps O'S shares quality dividend ETFs. that's OUSA. This is sort of the big cap version of OUSM. You screen, it's the same thing here. You screen for high quality, high dividend yield, low volatility.

I look at the biggest holdings here. I see Microsoft, I see Apple, J.P. Morgan. I see a little tech like Broadcom and Verizon. Tell us what we're looking for here. And under what circumstances would this outperform, for example, the S&P 500? Well, I do think that, In some ways, what you just laid out, Bob, in terms of those top holdings, looking very similar to what some of the top holdings are in the S&P 500 speaks to what Mike talked about.

The S&P 500 by nature is a fairly high quality universe of securities. Just looking at sort of your factor attribution, the nature of leverage is much lower in that large cap universe than it is in the small and midcap universe. And the profitability profile of the leading companies in the market is also significantly higher. So when you look at OUSA versus the S&P 500, it's going to be overweight health care, financials, industrials, it's underweight tech to a certain extent, not dramatically so, but it excludes, importantly, energy, real estate, and materials, three or two of the most volatile sectors in the market in the way of energy and materials. And so you're looking for dividends as part of the methodology, but you're looking at

dividends that are durable, dividends that have been growing, that are well supported by fundamentals and the juice from a factor perspective, if you want to. I call it that just isn't as dramatic as the juice from a factor perspective in OUSM relative to the Russell 2 or the S&P 6. Why does it exclude energy, real estate, and materials, Paul? Well, OUSM does the same, and I try and articulate the energy and materials exclusion this way. So if you think about the high-level story and even the name in OUSA and OUSM, they're both quality portfolios with low volatility mandates. And energy and materials are highly cyclical. all the fundamentals of those companies are also highly cyclical.

When things are good in the energy sector, when things are good in the material sector, their profitability profiles or net debt to EBTA might look better in those periods of time, whereas when things aren't good, when the cycle is in its bottom within energy and materials, you can see a significant deterioration in the fundamentals of those specific sectors. So not only do you have price volatility, but you have fundamental volatility in those sectors, which undermines the sort of high-level stated goal of OUSA and OUSA and OU. USM, which is to bribe, consistent drawdown avoidance. So essentially, the low volatility component here weeds out materials and energy, essentially.

Is that right? It's actually a rule in the index itself. Those sectors are excluded. And real estate's a different animal. A lot of people allocate to that sector independent of an equity framework. Okay. Regardless, Mike, this is still a somewhat defensive strategy, right? It seems to me this would tend to outperform during periods of maybe market underperformance.

No? I'm trying to figure. Yeah, I mean, I don't say. I definitely, the quality component is historically been less drawdowns, right? So Paul speaks to that really well. You're going to have less drawdown with cleaner balance sheets. That being said, I wouldn't put it in the like cyclical nature of value. It's it kind of leans towards value.

if I'm looking at OUSM right now, you know, it trades about 10%, 15% cheaper on a Ford multiple basis relative to the S&P 500. A big part of that is getting that yield. I think it yields closer to 2% on a weighted average basis versus one and a quarter for the S&B 500. But I think at the end of the day, this OUSA would be a better example of a core strategy where you're a little more defensive core strategy. The same can be said for OUSM, whereas a lot of the dividend strategies at the marketplace, the higher yielding strategies that are yielding three, three and a half, four percent on a weighted average basis. Those are deep value strategies. They're going to be higher volatile and they're going to either outperform by a lot or underperform by a lot, just given what

dynamic we are in the marketplace. Yeah, OUSM, OUSA are a little bit more core in that nature. So Paul, you've got another dividend strategy I want to get your thoughts on. It's essentially a spin-off of the dogs of the Dow strategy. This is the Alps sector dividend dog CTAF. The symbol is S-D-D-O-G. It tracks an equal-weighted index of the five highest-yielding S&P 500 securities in each sector. What's the idea here? What are we looking to do?

Well, the idea is at the beginning of the year, you just look at which stocks have the highest yield in each sector, and then you equally weight the top five stocks in those sectors, excluding real estate once again, as OUSM and OUSA do. And I think this gets to, and this is a nice segue, to Mike's point about what dividend strategies are. When you look at just yield-oriented strategies like Estog, they tend to be cyclical value because you look at the equal-weight sector approach of Estog, and you end up being underweight technology, you end up being overweight significantly, utilities, energy, as well as

some of the more defensive sectors like Staples. And as a result, you have a very different sector profile that is at the very least defensive. But within those sectors, you have a cyclical value orientation. And I would say this, Bob, and we talked about this a little bit prior, is that in a dividend strategy, because many of them that don't have the same guardrails as Zestog have big weights and utilities, you tend to have a lot of leverage in that portfolio on the balance sheet side. And the leverage factor has been one of those factors in the market that has been punished the most in this rising interest rate environment. So to the extent that you can tie some of these dynamics together, fed easing, declining interest rates, as maybe a signal that investors are

moving back toward dividends out of money markets, out of fixed income, but also importantly, toward leveraged companies that might be rewarded by a declining interest rate environment. That's the sort of sweet spot that Estog lives in. And Mike, having been at Alps previously, is very familiar with the strategy, I believe. Yeah. Well, let's just put up what we own here. I always like to put up the largest holdings. 3M, truest financial citizens, Bristol, Myers, Squibb, Altria.

It's kind of all over the place, but a large number of these are essentially 2%, as you can see. But that would make sense because there's essentially, what is there, 45 stocks in this? Paul, how many are in here? 50 holdings. with an equal weight at rebalance. There you go. So Mike, same thing here. This would, it seems to me tend to outperform

during periods of underperformance. It's, there seems to be slightly more defensive relative to the rest of the S&P 500, right? Yeah, I mean, at its core S-Dog is a contrarian strategy, right? And the idea being that you start the S&P 500 or similar construct, the S&P 500, those companies that have the highest yield, they're temporarily out of favor.

When the market brings their yield back in line, you get that alpha component to the strategy. STDog is a great segue as Paul mentioned when you're talking about factors. When I look at OUSA in our database, it has a quality score and an average yield score or a average value score. When I look at Estog, it has one of the highest value scores in our entire database of large cap ETFs, but it also has one of the lower quality scores, right? So it's a deep value. These companies are highly levered, as Paul mentioned, which is not going to help your quality score. Yet they're paying very high yield.

And to that extent from a macro environment, you know, when we're getting a broad market rally, when you're in a cyclical environment, Estog is going to tend to perform well. I wouldn't call it defensive, though. I don't think it's fair to call the strategy itself. It does overweight some of the defensive sectors because of that equal stock, equal sector component. but it really is a true value-driven strategy where it's going to rip when the market hits that environment and you're going to get a very nice yield while you wait for that to happen. Yeah. I wonder, Mike, if you give me your thoughts on dividend investing as a strategy itself

because there is a class of investors that absolutely loves dividends, but there has been a debate in academic circles for years that dividends don't really matter at all. That, for example, distributing a 2% dividend just drops the price of the stock 2% and the shareholder gets the 2% in cash. But that doesn't fundamentally change things. The balance sheet gets reduced by 2%. But some people seem to believe that getting a dividend is free money, but it's not. That would be a great trick. And yet, dividends have an enduring appeal.

Can you sort of explain that to everybody? Why? I mean, academically, it doesn't really change much at all, but people seem to love it. Let me add its course. So first and foremost, your first point, yes, dividend. If you look at the clear factors within the ETF universe, the dividend category, dividend factor is the largest by far, and it's not even close. It is by far in a way has the most assets allocated to it. And even over the past 10 years where by and large, the category is significantly underperformed, just like value,

flows continue to come into this space. So there is an appetite for yield. I like to think of dividends. And the investors and the clients that I talk to that are, you know, using dividends as their core, tend to believe that if it's a large cap, stable company and it pays a dividend, they think of it as a sense of quality.

They have the ability to maintain and raise that dividend. It's a quality aspect. We have not, we've been in an environment where your largest growth companies, especially your mega cap growth have outperformed. So it just has not worked in that sense because many of those companies up until recently didn't even pay dividends. So to that extent, they wouldn't even be in these indexes. But I can't, I don't have the crystal ball that explains why dividends are so invoked.

Other than, you know, I think people look at it as if you're paying a dividend and you have for years, there is a sense to buyability to that company's balance. Right. Paul, I'll give you the last word on this. I think the answer is people just like getting cash. And if you intellectually explain to them, you're not getting free money here. The company's value is being reduced by 2% per share if you're getting a 2% dividend. But people like that.

The academics will say, well, if you like getting 2% back, why don't you just sell 2% of your shares? It essentially would be the same thing. And yet there's an appeal. I think it's a behavioral economics thing, Paul. What's your thought? People just like getting money. Yeah, and you're a student of the markets, Bob. And so you know that historically a large portion of your total return profile in the stock

market has come from compounded dividends over time. That has been an important driver of returns. But recently, to Mike's point, price return has dominated a lot of that total return profile in the market. And it also speaks to this idea that not all dividend strategies are created equal. First of all, dividend yield can go down in a couple ways. You can either see the stock go up and the dividends stay the same. will go down all else equal or they can cut their dividend. And so simply focusing on yield can be a

fruitful strategy in the right context, but that's why you have strategies like say OUSA or others that focus on either dividend growth or the leverage profile, the profitability profile, the quality, if you will, of the dividends that are being provided by a company. So I don't think because we've had this period of sort of abnormal, if you want to call it, that total return profile in the market, that all of a sudden dividends aren't relevant, but I do think you make an important point, Bob, that there are tradeoffs from a capital exercise perspective that companies make when deciding to either issue a dividend,

support a dividend, grow a dividend, because ultimately they're sacrificing or trading off other things they can do with that capital. Right. Yeah, we can go round and round on this. I've been fascinated by this for years, but if your goal here is the wonders of compounding interest, taking that 2% dividend out and consuming it takes you out of the market by 2%.

You want to obviously reinvest the dividend, but a lot of people don't actually do that. So my point is that from a behavioral economics perspective, you can explain to people that doesn't make a lot of sense, but people like taking the dividend and somehow consuming it. I love talking about this subject. Now it's time to round out the conversation with some analysis and perspective to help you better understand ETFs.

This is the Market's 102 portion of the podcast. Mike Aiken's from ETF Actions continued with us now. Mike, thanks for staying with us here. I want to, we had an interesting discussion on small caps and on dividend payers. I want to touch on what's happening across the broader ETF landscape here. We were starting to see some indications of leadership change with small caps and value, having a little bit of a run against large caps and growth.

That does not seem to have resolved itself. There's no clear trend right now. We had great inflation data last week. Where do you think we are in this whole process? Yeah, I mean, I think we have seen this play out several times over the last several years where we get this head fake that, okay, you know, the Valley folks are finally getting an opportunity to cheer after years and years about performance. It happens violently to get a little catch up relative to the growth trade.

And then it kind of peters out. And I think our take here at ETF action is a little more nuanced. Some interesting things when you look at the size and style trade is the size of the companies that value versus growth hold. And we talk a lot about Meg 7. But to put Meg 7 into context, you know, if we look back 10 years on the S&P 500 growth index, the top 10% of that index, so the top 10 names made up 27% of the index on a market capitalization basis. Today, that is closer to 60%. And that is that Meg 7, right? So it's not really, it's becoming less about an index and more about seven to 10 companies

that are driving returns to the market. And our belief kind of on that, if you're going to get an environment where we see a change in leadership in the marketplace, part of it has to happen at those top names because regardless of what else happens to that other several hundred companies that are in that index, when 10 of them make up 60%. your returns are going to come from that 10%. And just the opposite is true with the value indexes, right? Go ahead.

So you're saying the only way that we're going to get an extended period of new outperformance from another sector is if the mega caps really essentially underperform. That makes some sense. But does the rest of the market have enough juice in it to be able to move forward? I mean, look what's happened in the last couple weeks. The advance decline line has been very, very strong recently. Tech has underperformed maybe a little bit recently, but the rest of the market is advancing.

The S&P 500 is, you know, recovered nicely here. Yeah, I mean, I think absolutely, if you look, the whole market is cheering on the lower inflation numbers. And we saw that in a big way last year, but no part of it cheered on it as much as the big tech names did. Right. We just look at last week, technology, was up, you know, six, seven percent. The defensive sectors were up one, two, three percent.

So big, broad-based rally, but the companies that benefited the most from that rally were the companies that have been benefiting the most over the last several years. And I think the thing that gets missed on this conversation is we think of indexing as being the diversified way to invest in the markets, right? You think S&P 500. That's just buying the market. And I believe buying the market, but the market right now is at extremes relative to historic averages. The concentration in certain sectors, technology specifically is higher than it's been since the dot-com buffs, the concentration in single names as as high as it's been since the dot-com bust. So the extremes and the excesses in the market that is being driven by a handful of companies

being these trillion-dollar companies. Another way to look at it, this is a crazy stack to me. What are you, the question is, what are you would, what are you or anybody else advising people to do? What if I have an S&P 500, a small cap index or a, and a midcap index, should I own a small cap quality? What, I mean, what's, what are you advising people to do here, if anything? Yeah. So I don't, I don't know if I'm advising anybody to do anything. I think strategically owning a big chunk of your portfolio in the market makes a lot of sense.

I know, you know, you're a big believer in kind of that band, story. I am as well. I think what you can do is you can change your portfolio a little bit on the edges with equal weight type strategies like an RSP or deep value strategies where you don't have to buy much to get a lot of protection if that leadership changes. So if you can, you know, add certain types of strategy that have a lot of exposure to what's been out of favor, but not a big portion of your portfolio, if that reverses, it can really protect you versus. a big pulldown with those strategies that are going to do well. All right, Mike, we're going to have to leave it there.

Thanks very much for joining us. Mike Agens is with ETF action. Everybody, thank you for joining us on the ETF Edge podcast. Join us next week or head to our podcast. Of course, all the shows are there. Etfedge.c.cc.com. How does InvestcoQQQQR rethink possibility? By rethinking access to innovation and the NASDAQ 100.

Let's rethink. possibility. Invesco Distributors, Inc.