The Best and Worst of the Small Cap Growth Style 2Q16

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The Small Cap Growth style ranks eleventh out of the twelve fund styles as detailed in our 2Q16 Style Ratings for ETFs and Mutual Funds report. Last quarter, the Small Cap Growth style ranked eighth. It gets our Dangerous rating, which is based on aggregation of ratings of 12 ETFs and 430 mutual funds in the Small Cap Growth style as of May 4, 2016. See a recap of our 1Q16 Style Ratings here.

Figure 1 ranks from best to worst the nine small-cap growth ETFs that meet our liquidity standards and Figure 2 shows the five best and worst rated small-cap growth mutual funds. Not all Small Cap Growth style ETFs and mutual funds are created the same. The number of holdings varies widely (from 18 to 1209). This variation creates drastically different investment implications and, therefore, ratings.

Investors seeking exposure to the Small Cap Growth style should buy one of the Attractive-or-better rated ETFs or mutual funds from Figures 1 and 2.

Figure 1: ETFs with the Best & Worst Ratings – Top 5

NewConstructs_SmallCapGrowthETFRatings_2Q16

* Best ETFs exclude ETFs with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

First Trust Small Cap Growth AlphaDEX Fund (FYC) is excluded from Figure 1 because its total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

Figure 2: Mutual Funds with the Best & Worst Ratings – Top 5

NewConstructs_SmallCapGrowthMFRatings_2Q16

* Best mutual funds exclude funds with TNAs less than $100 million for inadequate liquidity.

Sources: New Constructs, LLC and company filings

River Oak Discovery Fund (RIVSX) is excluded from Figure 2 because its total net assets (TNA) are below $100 million and do not meet our liquidity minimums.

SPDR S&P 600 Small Cap Growth ETF (SLYG) is the top-rated Small Cap Growth ETF and Virtus Small-Cap Core Fund (VSCRX) is the top-rated Small Cap Growth mutual fund. SLYG earns a Neutral rating and VSCRX earns an Attractive rating.

iShares Morningstar Small-Cap Growth ETF (JKK) is the worst-rated Small Cap Growth ETF and Goodwood SMID Cap Discovery Fund (GAMAX) is the worst-rated Small Cap Growth mutual fund. JKK earns a Neutral rating and GAMAX earns a Very Dangerous rating.

ICON, PLC (ICLR: $65/share) is one of our favorite stocks held by NRGSX and earns an Attractive rating. Over the past decade, ICON has grown after-tax profit (NOPAT) by 33% compounded annually. The company has improved its return on invested capital (ROIC) from 5% in 2005 to a top-quintile 22% over the last twelve months. An overreaction to quarterly earnings has dropped ICLR and created a good buying opportunity. At its current price of $65/share, ICLR has a price-to-economic book value (PEBV) ratio of 1.2. This ratio means that the market expects ICON’s NOPAT to grow only by 20% over the remainder of its corporate life. If ICON can grow NOPAT by just 8% compounded annually over the next decade, the stock is worth $99/share today – a 52% upside.

Cavium Inc. (CAVM: $48/share) is one of our least favorite stocks held by NSNAX and earns a Dangerous rating. Since 2007, Cavium’s NOPAT has declined from $250,000 to -$11 million. The company’s ROIC has fallen from 7% in 2010 to a bottom-quintile 0% over the last twelve months. Worst of all, Cavium has failed to generate positive economic earnings in any year since going public, which occurred in 2007. Despite the deterioration of Cavium’s business, the stock remains overvalued. To justify its current price of $48/share, Cavium must immediately achieve 5% NOPAT margins (compared to -3% in 2015) and grow revenue by 20% compounded annually for the next 23 years. In this scenario, Cavium would be generating over $27 billion in revenue in 23 years, which is greater than Qualcomm’s (QCOM) 2015 revenue. We feel this expectation is too optimistic.

Figures 3 and 4 show the rating landscape of all Small Cap Growth ETFs and mutual funds.

Figure 3: Separating the Best ETFs From the Worst Funds

NewConstructs_SmallCapGrowthETFLandscape_2Q16

Sources: New Constructs, LLC and company filings

Figure 4: Separating the Best Mutual Funds From the Worst Funds

NewConstructs_SmallCapGrowthMFLandscape_2Q16

Sources: New Constructs, LLC and company filings

Disclosure: David Trainer and Kyle Guske II receive no compensation to write about any specific stock, style, or theme.

Click here to download a PDF of this report.

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