DFAS ETF: Cost Of Capital Could Hit Smallcaps Hard – Sell (NYSEARCA:DFAS)

The Dimensional U.S. Small Cap ETF (NYSEARCA:DFAS) benchmarks against the Russell 2000 Index to offer smallcap exposure to investors in an attractive and relatively inexpensive (0.26% expense ratio) package that attempts to do the following:

maximize the after tax value of a shareholder’s investment. Generally, the Advisor buys and sells securities for the Portfolio with the goals of: (i) delaying and minimizing the realization of net capital gains (e.g., selling stocks with capital losses to offset gains, realized or anticipated); and (ii) maximizing the extent to which any realized net capital gains are long-term in nature (i.e., taxable at lower capital gains tax rates).

You’ll see the effects of this in the Historical Returns section further down the article, but the strategy itself seeks to reduce your tax obligations (assuming your funds are held in a taxable account) using the two approaches quoted above, which essentially look to reduce overall capital gains and, in particular, short-term capital gains.

Thesis: Smallcaps are growing at reasonable rates but still well below the broad-market average. DFAS is beating its benchmark, the Russell 2000 on a pre-tax basis on most time frames, particularly due to the value and profitability biases applied to this actively managed fund, but the market is chasing growth right now and has no time for value stocks. Moreover, neither an economic view nor a more granular look at the cost of acquiring fresh capital paints a better picture, as this analysis hopes to show. For that reason, I rate DFAS a Sell, because you’ll have to bide your time for a long time, and your money is better off being rotated into growth investments over value investments at this time. I’d recommend a buy if some catalysts were to appear on the smallcap horizon, but it’s still dark out – and very much so, unfortunately.

Holdings, Strategy, and Sundry Items

DFAS is heavily weighted to Industrials and Financials, with a second tier of Consumer Cyclical and Technology, with their respective portfolio weights as of March 5, 2024, being 19.19%, 18.44%, 14.93%, and 14.73%. Healthcare has a weighting of about 10%, but most of the remaining sector holdings are in the mid-single digits or lower.

This distribution is a crucial consideration because the market’s momentum right now is heavily tech-driven, with The Magnificent 7 having carried the bulk of SP500’s returns over the past year or more and continuing to do so, which you can see by the strong pandemic-driven returns in tech until 2022 (a down year for tech) that resumed last year and is still showing signs of inherent strength and momentum.

I’ve spoken about this in several recent articles, particularly on ETFs such as (FELG), (EQLS), and (GSUS). We’ll discuss this sector distribution in more detail later on in the article, but that’s a key component of my thesis for DFAS because tech still comprises nearly 15% of the fund. This could be one of the saving graces due to which the ETF hasn’t underperformed the benchmark index, the others being Industrials and Financials, both of which are cyclical sectors.

In terms of underlying securities, since the fund is market-cap weighted to reflect the Russell 2000, the distribution of allocations is limited to a maximum of 0.52%, and that honor goes to Comfort Systems USA, Inc. (FIX), a century-plus-old company that provides electrical and mechanical services to its U.S. clientele. You won’t see any other stock over that 0.50% threshold due to the spread of allocations spanning 2052 companies.

Within that cap allocation, the fund also prioritizes stocks that are trading below their peers in terms of price-to-book, or value stocks, as well as companies that have strong returns on assets or book value. This is important to know since these companies have a better chance of being rerated higher as investor sentiment moves toward value. Unfortunately, we’re not in that part of the value cycle because growth seems to be everyone’s focus despite the arguably shaky financial and political situation in the U.S. and the world at large.

The fund itself was originally established in 1998 as a mutual fund but has since been recategorized as an ETF with a listing date of June 14, 2021. The latest AUM data shows $7.8 billion in managed assets, with an average 30-day trading volume of around 300k, which is down from a high of over 450k at the end of 2023 but still fairly liquid. This is another important consideration if you’re planning on either building or exiting a large position quickly.

Historical Returns

Moving to returns, DFAS has performed relatively well in the past, returning well above hypothetical Russell 2000 Index returns on a 1Y, 5Y, and 10Y basis. However, remember that it’s only operated as an ETF from the middle of 2021, giving us a little shy of three years’ worth of usable data. If you look at that particular timeline, the fund has seriously underperformed the broader market’s total return.

If you take a closer look, you’ll see that DFAS’ total return caught up with the overall market’s around November 2022 and held on until about March 2023, but the tech rally since then forced a divergence that still exists today, and more pronouncedly so.

In other words, even a broad-market ETF such as (SPY) would have been a better investment over the past two and a half to three years. That’s only relevant in hindsight, of course, but the current situation, to me, is a sign that all’s not well with this ETF. We’ll explore that downside in more detail in the following sections.

Is DFAS a Good Investment Now?

We’ve already seen that the growth factor is driving the overall market to newer and newer all-time highs, with the SP500 now at a level never seen in the last 100 years of the S&P 500’s existence. For trivia lovers, the index was first introduced in 1923 with less than half the number of current holdings (233 vs today’s 503), and it was not until 1957 that it was expanded to include 500 companies domiciled in the United States.

Against this stellar performance of the overall market, DFAS didn’t stand a chance. You saw the divergence that has widened now, and that divergence will continue as long as the fund’s weightings are skewed to other industries and sectors apart from technology, even the surprisingly resilient ones like Industrials and Financials.

The Interest Rate Perspective

Notice that I said “didn’t stand a chance”, specifically using the past tense. The reason I did that is because DFAS might actually offer some solid downside protection should interest rates start to drop. Truth be told, however, that’s a long shot at best. Nobody except the Fed knows when this will happen, but it’s increasingly looking like the rate pause since the middle of last year could last a while.

At this point, I’d like you to join me in studying the Fed’s viewpoint. The graph above is part of the Monetary Policy Report – March 2024 that the Fed recently submitted to Congress at the start of this month, and I’ve extracted a clue to the direction the Fed might take in the near term:

The Committee has indicated that it does not expect it will be appropriate to reduce the target range until it has gained greater confidence that inflation is moving sustainably toward 2 percent. In considering any adjustments to the target range for the federal funds rate, the Committee will carefully assess incoming data, the evolving outlook, and the balance of risks.

This is just my opinion alone, so I don’t expect everyone reading this to agree with me, but it looks like the Fed is extremely hesitant to start reducing interest rates again. The statement quoted above makes it a near certainty (again, to me alone) that the FOMC meeting later this month will NOT yield positive results for investors looking at lower rates in the near future.

As such, everyone, including the Fed, will be watching very closely as the U.S. Bureau of Labor Statistics publishes Feb 2024 CPI data on March 12, just a few days from now.

According to a senior contributor at Forbes:

Consumer Price Index data for February is expected to show relatively high monthly inflation on nowcast estimates compared to recent data. If this forecast holds, that would be similar to January, where inflation sees a relatively high monthly increase, but stays close to 3% in terms of the annual inflation rate.

Again, in my opinion, it will likely prompt the Fed to hold fast to its current rate range of 5.25% to 5.50%. Furthermore, another look at the Fed table from the report above shows us that the collective median expectation for Core PCE inflation is a slightly lower 2.4% compared to the September 2023 projection median of 2.6%, BUT the median expected Fed funds rate for 2024 is still high at 4.6%. Although significantly lower than the September 2023 expectation of 5.1%., it’s not exactly a full return to a normalized interest rate environment.

Another important point to note here is that the Fed Reserve bank presidents and board members, whose individual assumptions this dataset represents, still have 5.4% at the higher end of the range for Fed funds rate expectations for 2024. The implication is that some board members and presidents at the Federal Reserve still think that rates won’t be lowered at all this year.

Of course, we need to recognize that this data is from December 2023 and we haven’t yet had the next key data point coming out this month – the dot plot, which is only released four times a year; nevertheless, it doesn’t bode well for the economy as a whole. As a matter of fact, at least a few of them think that Fed funds rates should continue to be at the current 5.4% level right through 2025. Not a good sign that the Fed is optimistic about a return to normalcy on interest rates any time soon.

Implications for Smallcap Companies in the U.S.

Shepherding our thoughts back to the task at hand, this could have multiple implications for the smallcap sector as a whole. For now, it’s still growing, particularly due to the rapid growth of the professional business services sector and, surprisingly, the real estate sector, in Q1 2023, which together made up one-quarter of the country’s annualized GDP with 13% and 12% representations, respectively.

Those were the biggest contributors the last year’s national productivity, but even more interesting is the fact that, not surprisingly, software publishers and providers of computing infrastructure, hardware, and related services are expected to grow the strongest over the next decade, per employment projection data released by the U.S. Bureau of Labor Statistics. Nvidia (NVDA), anyone?

Enter the Magnificent 7!

Please stay with me through this seemingly tangential discussion.

Why are these companies growing so fast? There are a couple of reasons that stand out for me.

One, everybody and their grandmother’s dead cat is migrating toward the cloud, but we’re surprisingly far away from reaching any kind of saturation point. The numbers make it look that way, with 94% cloud adoption in the enterprise segment. Reading into it reveals a different story – that growth is still strong at a 15% CAGR that will effectively double the global cloud market to $1.2 trillion over the next five years and nearly $2.2 trillion by 2032.

That’s why compute and cloud infrastructure, hardware, and software are expected to grow the fastest, as we saw from the BLS data above.

Two, AI revenues are on an aggressive growth path as the world’s biggest tech companies fight for this very valuable prize. Hundreds of billions of dollars are going into AI-related spending, and with the kind of ROIC these companies already enjoy (see next section), it’s harder and harder for smaller players to remain competitive with their own capital expenditures, as we discuss in the next section.

How is that relevant to smallcaps?

The problem with this is that it will lead to the big getting bigger because – and now I tie this back to my arguments around interest rates – these businesses don’t need fresh infusions of debt or equity capital to grow even bigger. Sure, big companies do have debt and keep issuing equity, but they also typically have very handsome rates of return on assets, equity, and capital as well as liquidity ratios. I won’t even talk about the collective billions that are getting them hefty money-market rates with their cash and cash equivalents and yielding unrealized capital appreciation as well as dividend income through their short and long-term investments.

My point here is that these companies use debt and equity issuance very strategically, and only if it returns more than a buck on the dollar. They’re not likely to lose sleep (or money) over their debt situations. Yes, higher interest rates apply to them as well, but as we’ll see in the next section, it doesn’t cost them as much as it does smallcaps, which is why this argument is relevant to smallcaps.

A Study of Weighted Average Costs of Capital – WACC

This is where the rubber hits the road and my thesis starts to come together. Higher prevailing interest rates mean the cost of borrowing is more expensive than ever before. As an example, Microsoft Corporation’s (MSFT) WACC is currently at 10% per GuruFocus data, which is around where Prof. Aswath Damodaran sees it for those industry subsets (See Software (Internet) and Software (System & Application.) However, a closer look reveals a much lower pre-tax debt cost for those subsets of around 5.3% to 6.1% but a much higher equity cost in the range of 9.8% to 11.3% due to the high equity risk premiums in the current market.

Smallcaps also rely on both debt and equity to fund their growth, but aside from having equivalent equity risk premiums to large-caps, they pay much more out of their earnings to service their debt. S&P Global Market Intelligence data shows a very high interest burden of 6.8% for small businesses against just 2.6% for larger corporations. And it’s pushing toward 7% this year. EY-Parthenon economists don’t see that coming down any time soon, either.

What happens when capital costs more?

The knock-on effect this has on a company’s operations is significant, as you can imagine. Projects with low ROIs are completely off the table, and CEOs are forced to look at increasingly higher rates of return for the capital they invest in their growth. They can’t afford to be frivolous with their capex, in other words; and, to the extent possible, whatever capex outlay can be squeezed out of operating cash flows should be prudently spent on growth, with only the bare minimums going into maintenance. If not, the only recourse is raising capital, which is expensive on both the equity side as well as the debt side.

Not all companies in the smallcap segment are nimble enough or agile enough to do that, so it shouldn’t be surprising that companies that aren’t capable of delivering those kinds of core returns on invested capital eventually spiral down the whirlpool to eventual bankruptcy.

But the economy is improving, you interject. What about that?

Right back at you with this: if the economy is improving, why did 591 corporations file for bankruptcy in 2023 – the highest number in over a decade and not much lower than pandemic-year bankruptcies (639)?

In three words, COST OF CAPITAL! Due to the fact that smallcaps are paying increasingly more to service their debt and often need to have that debt refinanced at even higher rates, this has a tendency to spiral out of control, which is what happened in most of those hundreds of corporate bankruptcies.

By now, you should be convinced that the cost of capital is a crucial component in deciding whether or not to invest in DFAS (whew, he finally got there!)

To Summarize…

I don’t think it’s prudent to hold on to your smallcap holdings in the current environment. Growth seems nominal, however, so why am I rating DFAS a Sell rather than a Hold? The main reason is that the high cost of capital will eat into any future profitability for the companies in this segment, and it could get a lot worse in the event of a recession. Although that probability is now somewhat fading into the larger narrative around growth, it’s a risk you should factor into any financial model you build. That risk being extremely high at this point and likely to stay at these levels for the foreseeable future, I think your money will serve you better if you rotate it into growth stocks or growth-focused ETFs.

That’s my honest opinion. Thank you for reading my work, and I welcome any comments that help me improve my understanding of the markets.