Small cap writes on sticky note isolated on office desk. stock market concept
getty
Typically, when interest rates fall, we closed-end fund (CEF) investors are tempted to pick up funds like the Royce Small Cap Trust (RVT), which yields 7.3%.
This small-cap-focused CEF is trading at a 10.3% discount to its net asset value (NAV, or the value of its underlying portfolio), and seems like an especially smart move today. cheap!
But is it really a good value, or could RVT be even cheaper?
Let’s take a look at small-cap stocks in general. Like large-cap stocks, they benefit from lower interest rates as consumer spending increases. But there are two other factors that make a period of low interest rates particularly advantageous for small businesses.
This means lower borrowing costs for investors and the ability to invest with more margin than they would otherwise have. Small-cap stocks tend to carry more risk than large-cap stocks, attracting these more aggressive buyers. These help businesses have more money to spend on expansion. This tends to benefit small businesses more than large businesses, as small businesses tend to be more innovative.
With that in mind, plus the fact that small-cap stocks tend to be more domestically focused, helping insulate them from global instability, investors are looking to buy small-cap stocks by the month this year. You’d think they’d have bid up to , right?
Well, not really.
small cap lugs
Y chart
So far, traders aren’t looking for a rally in small-cap stocks, with the iShares Russell 2000 ETF (IWM), shown above in purple, underperforming the benchmark S&P 500 ETF (in orange). (IWM invests in all 2000 small-cap stocks that make up the Russell 2000, the leading small-cap index in the United States.)
At the CEF Insider service, we usually love contrarian setups like this, and this time we think this crowd has a point.
Lowering prices increases spending (but only at certain times)
It’s true that people spend more when interest rates are low. However, keep in mind that interest rates tend to be lower during recessions. And amid the recession, Americans are already cutting back on spending. Therefore, lower interest rates tend to boost consumer spending in such times, albeit from an already low base.
But when Americans are already spending a lot, as they are today, lowering rates doesn’t necessarily have a big effect.
Increase in spending ticks
federal reserve system
As seen above, consumer spending growth did not slow despite interest rates rising dramatically from near zero to 5.5% in just 18 months. Therefore, it does not make sense that lower interest rates would increase consumer spending. That usually happens, but probably not this time.
What about credit buying? That idea is also a little broken.
credit loan, interest rate
federal reserve system
As you can see, lower credit borrowing costs (related to the federal funds rate, shown in red in the chart above) have resulted in massive credit borrowing (blue line) during the pandemic. However, the margin balance returned to its normal trend in 2022 when interest rates rose. Incidentally, this was the main reason for the stock price to plummet that year.
In other words, the market has already reached “normal” levels of credit borrowing. A drop in interest rates from 5% to 3%, which the Fed wants to keep rates steady, is unlikely to trigger the kind of speculative buying into small-cap stocks that we saw in the immediate aftermath of the pandemic, or even in the 2010s. , when interest rates were also low.
This also means that this chart is unlikely to repeat.
IWM tracks SPY
Y chart
It started during the low interest rate era of the 2010s, when small-cap stocks were oversold during the Great Recession. But they just tracked the S&P 500, even with a lower starting point.
In other words, when interest rates were 0.25% instead of 3%, investing in small-cap stocks based on the idea that someone else would borrow and invest was not a good move. This brings us to our final point: investing in small-cap innovation.
Over the past decade, technology has become a huge part of the overall U.S. stock market as technology companies have provided incredible innovation. Companies across the economy are increasingly reliant on the likes of Alphabet (GOOGL), Microsoft (MSFT), and Oracle (ORCL). More than ever. This trend has continued since the end of the dot-com bubble. The current scramble among large companies to integrate AI will only make matters worse.
That’s why the top constituents of IWM, a major small-cap index fund, are of concern.
IWM Top Holdings
iShares.com
There are good companies here like FTAI Aviation (FTAI), which does jet engine repair and maintenance.
However, as several industry reports (such as this article and this article) have pointed out, major airlines such as Boeing (BA) and Airbus are already leveraging AI to improve aircraft maintenance services. Masu. Therefore, small businesses like FTAI need to invest in cutting-edge AI technology to compete.
This will put pressure on the profits of small and medium-sized enterprises more than those of large corporations. But the main winners will be the companies that provide the AI infrastructure needed by both FTAI and Boeing, such as Amazon.com (AMZN) and NVIDIA (NVDA).
This small-cap CEF looks cheap, but it could get even cheaper.
Now back to RVT. While a 7.3% yield sounds great, it’s actually low for a CEF with an average yield of 8.2%.
And while we at CEF Insider love to be contrarian, we can’t be contrarian in this case since RVT’s past performance shows it should actually be cheaper. Let me explain.
RVT Total Return Value
Y chart
RVT’s market price (purple above) has significantly outperformed IWM over the past decade. However, the picture looks different when comparing RVT’s total NAV returns, which reflect the actual performance of IWM and CEF managers.
RVT Total Return NAV
Y chart
In fact, RVT tracks a small-cap index over the long term, and if its discount drops below 15%, it would be a great entry point. However, given that RVT’s 10-year average discount rate is 11.1%, even a 10.3% discount rate is still not a bargain for us.
Michael Foster is a Principal Research Analyst at Contrarian Outlook. For even more great income ideas, click here to read our latest report, “Eternal Income: 5 Great Value Funds with a Consistent 9.3% Dividend.”
Disclosure: None
