Best & Worst ETFs and Mutual Funds: Small-cap Growth Style

The Small-cap Growth style ranks tenth out of the twelve fund styles as detailed in my Style Rankings for ETFs and Mutual Funds report. It gets my Dangerous rating, which is based on aggregation of ratings of 10 ETFs and 432 mutual funds in the Small-cap Growth style as of May 3, 2013. Prior reports on the best & worst ETFs and mutual funds in every sector and style are here.

Figure 1 ranks from best to worst the seven 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 27 to 1,344), which creates drastically different investment implications and ratings. The best ETFs and mutual funds allocate more value to Attractive-or-better-rated stocks than the worst, which allocate too much value to Neutral-or-worse-rated stocks.

To identify the best and avoid the worst ETFs and mutual funds within the Small-cap Growth style, investors need a predictive rating based on (1) stocks ratings of the holdings and (2) the all-in expensesof each ETF and mutual fund. Investors need not rely on backward-looking ratings. My fund rating methodology is detailed here.

Investors should not buy any Small-cap Growth ETFs or mutual funds because none get an Attractive-or-better rating. If you must have exposure to this style, you should buy a basket of Attractive-or-better rated stocks and avoid paying undeserved fund fees. Active management has a long history of not paying off.

Get my ratings on all ETFs and mutual funds in this style on my free mutual fund and ETF screener.

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

Vanguard S&P Small-Cap 600 Growth ETF (VIOG), Guggenheim S&P Smallcap 600 Pure Growth (RZG) and PowerShares RAFI Fundamental Pure Small Growth Portfolio (PXSG) are excluded from Figure 1 because their total net assets (TNA) are below $100 million and do not meet our liquidity standards.

Vanguard S&P Small-Cap 600 Growth ETF (VIOG) is my top-rated Small-cap Growth ETF and Virtus Small-cap Core Fund (PKSFX) is my top-rated Small-cap Growth mutual fund. VIOG earns my Dangerous rating and PKSFX earns my Neutral rating.

Vanguard Small-Cap Growth ETF (VBK) is my worst-rated Small-cap Growth ETF and Forum Funds: Adams Harkness Small Cap Growth Fund (ASCGX) is my worst-rated Small-cap Growth mutual fund. VBK earns my Dangerous rating and ASCGX earns my Very Dangerous rating.

I am astonished that no ETFs or mutual funds in the Small-cap Growth style earn an Attractive rating, as 290 stocks (over 15% of the market value) in Small-cap Growth funds are rated Attractive-or-better. Figure 3 shows details on how investors allocate capital to stocks, ETFs and mutual funds in this style.

The takeaways are: mutual fund managers allocate too much capital to low-quality stocks and Small-cap Growth ETFs hold poor quality stocks.

Sources: New Constructs, LLC and company filings

As detailed in “Cheap Funds Dupe Investors”, the fund industry offers many cheap funds but very few funds with high-quality stocks, or with what I call good portfolio management.

Investors should avoid Small-cap Growth ETFs and mutual funds, as 10 out of 10 ETFs and 410 out of 432 mutual funds (85% of total net assets) in the Small-cap Value style earn a Dangerous-or-worse rating. No Small-cap Growth ETFs or mutual funds earn an Attractive-or-better rating. Investors should focus on individual stocks instead.

Plantronics (PLT) is one of my favorite stocks held by Small-cap Growth ETFs and mutual funds and earns my Very Attractive rating. PLT has grown its after tax profit (NOPAT) by 24% compounded annually over the past decade, and it has a top-quintile return on invested capital (ROIC) of 29%. Those two numbers tell quite a story by themselves; you won’t get that kind of economic profitability from many other small-caps. One would expect a company with such impressive fundamentals to command a lofty valuation, but the market has very conservative expectations for PLT. At its current valuation of ~$43.55/share, PLT has a price to economic book value ratio of only 1.1. Such a low valuation implies that PLT will grow NOPAT no more than 10% from its current level for the remainder of its corporate life. Modest growth expectations combined with a strong track record of growth makes PLT a great stock for investors seeking exposure to the Small-cap Growth style.

InnerWorkings Inc. (INWK) is one of my least favorite stocks held by Small-cap Growth ETFs and mutual funds and earns my Very Dangerous rating. INWK’s reported earnings are positive and increasing while its economic earnings are negative and declining ($0.37/share versus -$0.22/share). Economic earningsare a much more accurate representation of the true profitability of the company. However, investors are clearly focusing on the reported EPS, as INWK is currently priced for surprisingly high growth. To justify its valuation of ~$9.92/share, INWK needs to grow NOPAT by 20% for 11 years. Given that INWK acts essentially as a middleman, connecting clients to printing suppliers, it’s hard to picture a scenario where it manages such drastic growth. Investors can find other companies with better growth potential and stocks with more reasonable valuations.

Figures 4 and 5 show the rating landscape of all Small-cap Growth ETFs and mutual funds.

My Style Rankings for ETFs and Mutual Funds report ranks all styles and highlights those that offer the best investments.

Review my full list of ratings and rankings along with reports on all 10 ETFs and 432 mutual funds in the Small-cap Growth style.

Sam McBride contributed to this report.

Disclosure: David Trainer owns PLT. David Trainer and Sam McBride receive no compensation to write about any specific stock, sector, style or theme.