The One ETF to Buy During This Small-Cap Comeback

1 | By Michael A. Robinson

In our twice-weekly conversations, I’ve made several big calls about the direction of the market.

For instance, in October 2013 I was among the first tech analysts to predict Apple Inc. (Nasdaq: AAPL) would hit $1,000 a share, or a split-adjusted price of $142.85. With more than a year left on my Labor Day 2016 deadline, it’s just 11% shy of that.

Last December, when others were warning of a tech correction, I said the technology sector would beat the overall market in 2015. So far this year, the Nasdaq Composite Index is up nearly 5%, compared to breakeven for the Standard & Poor’s 500 Index.

And today I have another prediction.

Better yet, I’ve found a way to profit from it…

A Small-Cap Summer

I believe this will be the “Summer of the Small-Cap Comeback.”

Before I explain why this will be so, however, let’s take a look at why small-cap firms – public companies with market capitalizations of $300 million $2 billion – are so important to tech investors.

Obviously the most attractive aspect of a small-cap stock is its potential to show massive returns. One reason is that small-cap firms can grow so quickly. After all, a $350 million biotech can double in size in a few years. A $20 billion company cannot.

In January, Barron’s reported on a study showing that small-cap stocks do indeed outperform larger ones – if you select “quality” stocks. Quality is measured by looking at things like profit growth and earnings stability.

This study basically reaffirmed a principle that investors have long known: There is a decided “small firm effect” or “size premium” that allows small-cap stock to consistently beat larger ones.

Consider that, over the past decade, the closely watched Russell 2000 Index of small caps has beaten the S&P 500 by roughly 26%.

While small caps’ performance this year has roughly matched that of the overall market, small-cap gains in the last eight months have outpaced the overall market.

Here’s why. A year ago this week, Wall Street became convinced that the U.S. economy was on the verge of significantly slowing down.

As a result, from July 2 to Oct. 14, 2014, the Russell 2000 fell more than 11%. That was more than double the S&P 500’s decline over the same period.

But Wall Street is once again waking up to the fact that the U.S. economy and small-cap stocks are great places to make money. That the Russell 2000 made up all that ground in the last eight months to come even with the S&P clearly demonstrates that fact.

Just last week, the U.S. Commerce Department revised its growth estimates for this year’s first quarter upward by 71%. Commerce had originally said gross domestic product (GDP) fell by 0.7% in the quarter but the decline was actually just 0.2%.

The news came on the heels of strong job growth. In early June, the U.S. Labor Department said the economy added some 285,000 nonfarm jobs in May, the last month for full data.

It was the highest job growth since December and means that the economy has added more than 1 million jobs so far this year.

Meanwhile, the bellwether housing sector also is reporting robust growth. On Monday, the National Association of Realtors said its index of pending home sales increased 0.9% to a seasonally adjusted 112.6 – the highest level since April 2006.

And there’s one more factor that bodes well for the Summer of the Small-Cap Comeback.

A Perfect Ratio

As a group, these smaller firms are priced to move. You can see that in the forward price to earnings (P/E) ratio. I use this ratio all the time because it tells me how much I’m paying for next year’s earnings.

Right now, the Nasdaq 100 Index, which includes big-cap leaders like Cisco Systems Inc. (Nasdaq: CSCO) and Intel Corp. (Nasdaq: INTC) is trading at 19.45 times next year’s earnings.

But the Russell 2000 has a forward P/E ratio of just 19.25. In other words, you can buy a basket of small, hyper-growth companies for less than their mega-cap counterparts.

That’s why I think every tech investor ought to own the iShares Russell 2000 Growth ETF (NYSE: IWO). As the name implies, this exchange-traded fund seeks to mirror the performance of the Russell 2000 – and it’s selected those “quality” stocks I mentioned earlier.

This is a “twofer” investment. It gives us exposure to not only fast-moving tech small-caps but also small companies in other growth sectors.

Information technology and health care, which includes biotech and medical equipment, make up 51% of the fund. Other industries represented include heavy industry, financial services and consumer discretionary.

But make no mistake. Exciting tech leaders form the core of the IWO.

In fact, it includes two members of The Million Dollar Tech Portfolio, which delivered to you on March 6.

Two “Million Dollar” Winners

The first is video-processing chip firm Ambarella Inc. (Nasdaq: AMBA). Over the past three years, Ambarella has grown its sales by 32% and its earnings by 52%.

By comparison, Cisco has grown its sales by just 1% and its earnings per share by 6% over the same period.

More pertinent to us, as investors, Ambarella’s share price has soared 212.21% over the past year, while Cisco’s has inched up 8.06%.

IWO’s other Million Dollar Tech Portfolio holding is biotech supply firm Repligen Corp. (Nasdaq: RGEN). Over the past three years, it has grown sales by 16% and earnings per share by 45%.

Then there’s Qorvo Inc. (Nasdaq: QRVO). It’s known as a supplier of radio-frequency chips used in defense, cable TV systems, tablets and smartphones.

Qorvo boasts an impressive list of marquee clients – including The Boeing Co. (NYSE: BA), Raytheon Co. (NYSE: RTN) and Sony Corp. (NYSE ADR: SNE). Qorvo has 15% operating margins and sales by 148% in the most recent quarter.

IWO also owns specialty e-commerce firm Blackbaud Inc. (Nasdaq: BLKB), which caters to nonprofits such as research foundations and universities.

Blackbaud has some 29,000 clients that rely on the firm for help in managing their fundraising, accounting, online marketing and payment services. With a market cap of $2.6 billion, Blackbaud has a 16% return on equity and recently grew its quarterly earnings by some 16%.

Aspen Technology Inc. (Nasdaq: AZPN), the fund’s 10th-largest holding, is another high-margin firm in the IWO portfolio. The software company’s products help manufacturers cut costs, improve supply-chain efficiency and increase profit margins. Aspen has an astounding return on equity of 384% and grew its most recent quarterly earnings by 35%.

Not only does IWO provide investors access to more than 1,200 stocks in a single ETF, it also offers market-beating performance.

After the market’s big selloff on June 29, the S&P was at breakeven for the year. But IWO’s return for the period came in at 8%.

I’m calling this a comeback.

However, it remains true that small-caps can be riskier than their large-cap cousins.

But with the IWO doing the “picking” for you, it’s the kind of foundational technology play that you can count on over the long haul to keep you on the road to wealth.

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