IJH: Mid-Caps Looking Cheap When Valuations Are Considered (NYSEARCA:IJH)

Thesis

The rally in the past year has been nothing short of astounding, with the S&P 500 index producing a return in excess of 27%. The story has been centered around artificial intelligence and the tech mega-caps, which have attracted an enormous amount of capital and interest. The rest of the market has moved higher, but has lagged substantially:

We can see from the above graph that the iShares Russell 2000 ETF (IWM) is up only 9.7%, the Invesco S&P 500 Equal Weight ETF (RSP) is up 11.3%, while the iShares Core S&P Mid-Cap ETF (NYSEARCA:IJH) is up only 13.4%.

Large caps, and specifically mega-tech large caps, have attracted all of the investor capital, catapulting P/E ratios towards the top of their historic ranges.

If indeed 2024 will be the year of a soft landing and a seamless transition to lower rates without any labor market or capital markets shocks, then we will be witnessing a year of the ‘great rotation’. We are of the opinion that a soft landing will direct client flows towards those pockets of the market where valuations are still low and risk/reward equations look compelling.

In this article, we are going to analyze IJH and its build. The article is going to articulate why from a valuation standpoint, IJH looks cheap when compared to large-caps, and the reasons which make the fund a compelling choice when rates move lower.

A mid-cap core allocator

As the name suggests, the fund falls in the Mid-Cap Core bucket as per Morningstar:

Let us revisit the definition of mid-cap names so that we get a better sense of the underlying names in this ETF:

Mid-cap stocks are shares of companies with total market capitalization in the range of about $2 billion to $10 billion. Along with large-cap stocks and small-cap stocks, mid-cap stocks are one of the three main stock categories and offer a compromise between the growth, risk and volatility tradeoffs of their larger and smaller counterparts.

Source: Forbes

While the likes of SPY focus on large and very large companies, IJH contains medium-sized enterprises. SPY has been the beneficiary of strong balance sheets and funding profiles via its holdings, while the likes of IWM, which focuses on small companies, has seen its performance lag due to funding issues at the companies’ level.

The ETF comes from iShares and is a passive investment vehicle, tracking the S&P MidCap 400 Index. The fund has over $80 billion in AUM and represents a cornerstone of many portfolios. As per the index literature:

The S&P MidCap 400 provides investors with a benchmark for mid-sized companies. The index, which is distinct from the large-cap S&P 500, is designed to measure the performance of 400 mid-sized companies, reflecting the distinctive risk and return characteristics of this market segment.

The S&P 400 is a market-weighted index, similarly to the S&P 500, and to note that its largest component Super Micro Computer (SMCI) is slated to move into the S&P 500 at the next rebalancing date.

Passive allocator

As mentioned above, IJH follows the S&P MidCap 400 Index, and thus represents a passive allocator to an index. As a passive exchange-traded fund, the vehicle simply follows the index along with its other peers in the sector, such as the SPDR S&P MidCap 400 ETF Trust (MDY).

The purpose of a passive allocator is to simply follow an index efficiently, which IJH does. What sets the fund apart is its liquidity and large AUM. The fund is the largest allocator to mid-caps at an AUM of over $83 billion, and thus provides for ample daily liquidity, making it a preferred choice for large institutional players who need ample daily volumes.

When valuations matter

The incessant rally in the tech mega-caps has seen the S&P 500 move to stretched P/E ratios versus historic metrics:

Courtesy of ‘The Daily Shot’ we can see a graphical representation of historic P/E ratios and current ones for major U.S. indices. The S&P 500 is significantly above the red line (the average), while the S&P 400 is historically cheap versus its forward P/E metrics.

The historic context is extremely important because on a long enough time-line, everything means reverts. If indeed we get a soft landing, do expect a relative underperformance in the SPY going forward, and a relative outperformance in IJH. Capital is going to get allocated to names which are still cheap on a valuation basis, and IJH is one of those names.

As per the iShares fund page, the latest ETF metrics are as follows:

The forward P/E ratio as of March 6 is 17.9x for the name, with a standard deviation of 20% and a P/B ratio of 2.4x.

No market participant can say for sure what the correct P/E is for a particular sector or industry, but one can always benchmark against long historic data sets and establish cheapness or richness versus historic averages. Presently, IJH falls in the cheap bucket.

From a fundamental standpoint, if the Fed does indeed cut rates in 2024, we will see an easing in funding conditions for mid-sized companies when compared to their larger peers. One of the factors holding IJH back has been the propensity for mid- and small-sized companies to rely more on floating rate funding, a structural feature which has proven costly during the current monetary tightening cycle.

Mid-caps outperformed during lower rates

If we look at historic performance during a lower rates environment, we can see IJH outperforming during the 2020-2022 period:

As the Fed aggressively cut rates post-Covid, IJH was favored post its drawdown, outperforming from May 2020 to February 2022. Expect a similar performance in a soft landing scenario coupled with the Fed cutting rates.

Mid-cap companies will get more attractive funding costs and profiles, which will translate into higher earnings and EPS figures.

Holdings Analysis

The fund has Industrials and Financials as its top sectors:

Industrials represent over 21% of the holdings, while Financials and Consumer Discretionary stocks come next at 16.11% and 15.8% respectively. We can notice that Information Technology is only fourth, which represents a different build when benchmarked against the S&P 500, which is very Tech heavy.

On an individual name basis, we can see the weighting skewed towards the names which have rallied the most in the past months:

As mentioned above, SMCI will be removed from the index, given it is going to be part of the S&P 500 next.

Key Risks

The main risk for going long IJH is a hard landing / recessionary economic scenario. The market is currently pricing a soft-landing, with a rotation taking place from extended S&P 500 equities into mid- and small-caps. A significant deviation from a soft landing scenario would see the rotation end, and capital depart towards safe assets such as treasuries and cash.

A secondary risk is constituted by ‘higher for longer’ lasting into 2025, with no Fed cuts this year. Mid-caps are helped at the balance sheet level by lower floating rates, thus a failure by the Fed to cut in 2024 represents a secondary risk factor for this name.

Conclusion

It seems the entire market is currently fixated on a handful of names driven by the artificial intelligence revolution. While we cannot deny the EPS benefits of AI, valuations are stretched for the SPY. If we benchmark P/E ratios versus historic norms, we find out that mid-caps are undervalued, while the SPY is stretched. IJH is an ETF which passively tracks the S&P MidCap 400 Index and represents a cornerstone of many portfolios. The fund looks attractive from a valuation standpoint, and a soft landing scenario should see a rotation from large caps toward cheaper, better valued mid-capitalization names.