Small cap moves back into the limelight with inflationary and overvaluation pressures, says Pacer ETFs

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Sean O'Hara Pacer ETFs

High valuations are worrying investors, leading to the start of a rotation away from a lot of what has been fashionable, says Sean O’Hara, president of USD6 billion Pacer ETFs, who notes that the Nasdaq is trading at 37 times earnings and there are major overweights in intangibles such as infotech, healthcare and information services. 

“If you go back to 1962, every time the S&P 500 is at 25 times earnings, there have been no instances where within the next five years the S&P’s return is positive,” O’Hara says. 

Fears of volatile or down turning markets and a new fear of inflation is driving investors to the firm’s Cash Cow series of ETFs, with the small cap ETF CALF doubling its assets in February and seeing performance of 37 per cent year to date. 

Small caps have proven they can outperform large cap stocks during periods of inflation, as they are generally geared towards their local economy, and so less impacted by a strong or weak dollar. 

However, they can be volatile. “Our Cash Cow suite is our value suite,” O’Hara explains. “We use a different metric to get to what is cheap in value as so many of today’s stocks are intangible assets like networks or technology, making a traditional price to book approach difficult.” 

O’Hara estimates that some 90 per cent of the S&P 500 is based on intangible assets. Pacer ETFs uses the free cash flow yield, divided by the firm’s enterprise value. “We like to buy names that have a high free cash flow yield,” he says.  

He observes that the financial adviser community is moving back towards small caps and value investing, which have been out of favour for some time. 

Both CALF and its larger cap version COWS, which is up 18.87 per cent year to date, have significantly outperformed the Nasdaq which is up 54 basis points, and both have enjoyed inflows. 

“Valuations in general have been stretched and we hope things will open up,” he says. “It’s been easy to just ride the markets but going forward, you might have to take a different approach to make money.” 

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