IWC: Risks And Disadvantages (IWC)

iShares Micro-Cap ETF (NYSEARCA:IWC) is a passively-managed investment vehicle betting on the smallest U.S. equities that constitute the Russell Microcap Index.

For a value investor, the lower echelons of the equity market offer countless opportunities. They are rich with candidates for a contrarian (i.e., a deep-value) portfolio owing principally to the size discount, which means small-size companies tend to trade at far more appealing multiples compared to larger counterparts, especially those that climbed to the mega-cap league. The smaller the size, the larger the discount should be.

Another tailwind is that the analyst community does not pay due attention to pearls hiding in the micro-cap segment which increases the chances of them being priced inadequately cheap given low investor attention. A classic example of an under-the-radar opportunity.

During the times of market ructions like this year, as I have pointed out in a few articles already, exposure to the value factor (reinforced by high quality to cut down on volatility and avoid taking unnecessary risks) is increasingly relevant, as deflating (‘bursting’ should be a better word here) bubbles are almost omnipresent, and even a minor profit miss and slightly downbeat guidance can ignite a ruthless sell-off. Meanwhile, cheaper stocks have a margin of safety, and, hence, should be relatively immune to the steep price declines.

This strategy looks solid on paper. But does a micro-cap portfolio like IWC offer better valuations, and, hence, a value investor’s safe haven protected from the storm raging in the growth/speculative growth/mega-cap tech echelon? Is its quality adequate enough? These questions and a few others are discussed in greater depth below.

Its valuation profile is not as attractive as it is supposed to be

At the moment, IWC oversees a vast and versatile portfolio of 1,765 equities, with the assets under management being around $938.4 million as of May 25.

Civitas Resources (CIVI) is the largest player in the mix, sporting a market cap of ~$5.87 billion and a weight of ~0.78%; CIVI has been one of the best performers in the IWC mix this year, with a price return above 49% as of May 26.

Other companies featured in the ETF’s portfolio are much smaller. A portion of the net assets is deployed to biotechs with just a few million in market value, like ~$4.2 million Kiromic BioPharma (KRBP) or ~$8.2 million SeqLL (SQL), to name a few; both have a weight below 0.01%.

The fund’s website shows a P/E of just 10x, which fairly looks like a steal. However, using an earnings-based ratio in the case of this micro-cap mix is a rather suboptimal decision given the natural limitations: as of my analysis using the data downloaded from the screener, at least 24% of the net assets are invested in unprofitable companies. I have excluded those stocks without a Quant rating and with missing profit margin data, so the figure might be even higher.

What I would like to do instead of focusing on the portfolio P/E is, as usual, harness the power of the Seeking Alpha Quant rating, namely the Valuation grade. The issue with this portfolio is that just ~37% of the holdings have an appealing rating of at least B-, while ~25.6% are overvalued given a D+ grade or worse. This figure has fairly disappointed me since I expected it to be well lower given the size discount inherent to this echelon, while the share of attractively priced shares to be close to 60%.

Most players that trade at a steep premium to their peers are from the healthcare sector (approximately 115 companies), like Inhibrx (INBX), a clinical-stage biotech firm, which has an F grade driven by the gargantuan EV/Sales and Price/Book ratios.

To give a bit more color, the table below summarizes the Quant factors for the top 20 holdings of the fund. As you can see, most have questionable valuation and robust growth prospects; quality is mixed.

The lower quality inherent to the micro-cap echelon magnifies risks as higher interest rates looming

As I said above, the size discount should push multiples for micro-caps much lower compared to the sector medians. This discount, in turn, is influenced by much weaker profitability (e.g., less stable or sometimes even negative margins) and softer capital efficiency of micro-size companies compared to the large-cap echelon, for example. And I was not surprised by the fact that only 30% of its net assets are invested in stocks with no less than a B- Profitability rating; only ~13% are in the A league. This is perhaps the lowest result amongst the ETFs I have discussed to date. Most large-cap-focused funds have this figure in excess of 90%. Such a small allocation means IWC constituents are poorly prepared for the higher interest rates era since they are not completely self-sufficient, and likely too dependent on external financing. Capital scarcity poses a serious threat to them.

Returns YTD point to the echelon being extremely sensitive to financing costs expectations

The IWC has a soft quality and imperfect valuation. This year, this combination translated into a negative 16.7% total return, which is much worse compared to the iShares Core S&P 500 ETF (IVV) that the reduction in growth premia has impacted, the iShares Core S&P Small-Cap ETF (IJR), and the Invesco S&P 500 Pure Value ETF (RPV); I use the latter as a barometer for large-cap value stocks’ performance.

In my view, the key culprit is that investors have been rotating out of players most exposed to the repercussions of higher interest rates; micro-caps are a perfect example.

It should be noted that IWC is heavy in financials, with an ~23.5% allocation. These players should do well in a higher-interest-rates environment as it bolsters their bottom lines. But contrary to anecdotal evidence, most financial stocks in its portfolio have been under pressure this year. The table below compiles the 25 most afflicted players from the sector:

For a better context, IWC also underperformed both IJR and IVV over the ten-year period (May 2012-April 2022), with a CAGR of ~9.95% vs. IJR’s ~11.8% and IVV’s ~13.6%. It should also be remarked that the Sharpe and Sortino ratios of 0.55 and 0.82, respectively, over that period point to the elevated risk that has not been rewarded with higher returns.

Measly distribution yield as a consequence of valuation, quality issues

IWC has a distribution yield of just 92 bps, a minuscule level, with a patchy growth profile. In 2021, before this year’s correction, the yield was even lower.

In my view, this is a direct consequence of both weaker margins inherent to the echelon, as well as the suboptimal valuation mentioned above. Hence, IWC is clearly a pass for dividend investors seeking consistent, durable, and competitive yields.

Final thoughts and other issues to consider

The micro-cap echelon of the U.S. market has been bearing the brunt of bearishness this year despite the hypothesis that micro-size companies are relatively immune to the growth premia issue due to their naturally cheaper valuations.

Among other IWC’s downsides worth mentioning are a rather burdensome expense ratio of 60 bps, expectable for a vast portfolio of only thinly traded names, and a large 30-day median bid/ask spread of 21 bps pointing to liquidity issues, which are, of course, intimately intertwined with the fund’s focus on companies with minuscule market values.

The verdict? Consider the risks examined above and act accordingly. Of course, do your own due diligence. My rating for IWC is Hold.