This month's market rotation into small caps is being led by a rebound in cheap stocks. A rally in small caps can sometimes be a sign of speculative fervor, but an analysis of the top-performing nonleveraged small-cap funds shows that it is the value factor finding a bid. According to FactSet, three of the top five small-cap exchange-traded funds in July are explicitly focused on value, including the iShares US Small Cap Value Factor ETF (SVAL) . That fund was up 11.4% for the month through Wednesday, compared to 7.4% for the broader iShares Russell 2000 ETF (IWM) . Meanwhile, the other two funds in the top five — ProShares Russell 2000 Dividend Growers ETF (SMDV) and SPDR SSGA US Small Cap Low Volatility Index ETF (SMLV) — are cheaper than the broader small-cap sector across multiple valuation metrics, according to FactSet. Several factors could be contributing to the small-cap rally, including the rising confidence among traders of a Fed rate cut in September. Companies that are profitable, however, should be in better shape to navigate a period of rate cuts and a slowing economy, said Sean O'Hara, president of Pacer ETFs. Investors can account for profitability by looking for stocks with lower price-to-earnings ratios, one of the metrics captured by many value funds. As of June 30, the broader IWM had a 14.4 P/E ratio, compared to about 11 for the value-tilted IWN, according to iShares. "For those companies that are small cap … that are not profitable, I don't think either the macro environment or the Fed cuts, or perhaps even the historic underperformance of small caps versus large caps, will be a big help," O'Hara said. The Pacer US Small Cap Cash Cows 100 ETF (CALF) is underperforming the IWM in July but has outperformed over the trailing three- and five-year periods. That fund focuses on stocks with strong free cash flow. Screening for value stocks can sometimes miss areas of trouble in the market. Todd Sohn, ETF strategist at Strategas, pointed out that some of the value funds have high exposure to regional banks and said investors might want to consider using active management within small caps. "Those managers, if they're good at their job, will be able to screen out the real junky stuff that is not really value but more of a trap," Sohn said.
