DEEP ETF: Margin Compression, Sluggish Growth, Liquidity Weigh On The Rating

The Roundhill Acquirers Deep Worth ETF (NYSEARCA:DEEP) is a passively managed fund with a solidly designed technique that locations emphasis on the worth, small-cap, and high quality elements.

After analyzing its holdings utilizing Searching for Alpha instruments and some different knowledge sources, I ought to conclude that DEEP has grossly succeeded in its effort to distill a really small-cap portfolio (in contrast to most of its friends with minimalist methods that I coated up to now), with spectacular publicity to the worth issue and enough profitability by the small-cap echelon requirements. Most significantly, its efficiency for the reason that technique change in October 2020 has been exceptionally sturdy, particularly throughout the heyday of the capital rotation in 2021 when the chief narrative was the rapidly abating pandemic that bolstered multiples growth in cyclicals. It additionally fared comparatively effectively throughout final yr’s bear market, beating the iShares Core S&P 500 ETF (IVV), although lagging the iShares Core S&P Small-Cap ETF (IJR) by about 1.5%.

Nevertheless, with the three principal threat elements detailed under within the notice, I’m of the opinion a Maintain score is an optimum one, in any other case DEEP would clearly be a Purchase.

Technique overview: the ability of the Acquirer’s a number of

DEEP underwent an intensive technique change up to now rendering whole returns delivered throughout probably the most a part of its historical past (since 2014) irrelevant, thus they are going to be ignored within the efficiency evaluation part.

As talked about on web page 6 of the prospectus, on June 22, 2020, the fund ceased monitoring the Deep Worth Index and switched to the Acquirers Deep Worth Index, which itself noticed a profound change just a few months later, reorienting from large-cap names to small caps.

The Acquirers Deep Worth Index is meant to characterize the efficiency of “a portfolio of 100 of probably the most undervalued, essentially sturdy shares drawn from the smallest 75% of shares listed in america by market capitalization assembly sure liquidity thresholds” because the DEEP prospectus succinctly put it. It’s reconstituted quarterly.

The inventory choice and weighting course of is completely described on web page 3. The philosophy of the index is predicated on the Acquirer’s a number of, a elementary worth indicator with metrics like debt, most well-liked inventory, minority pursuits, and working earnings at its crux. All the preliminary universe can also be screened scrupulously with property, earnings, and money flows primarily based metrics, with every candidate assigned a rank primarily based on its valuation traits. Subsequent, “statistical measures of fraud, earnings manipulation, and monetary misery” are taken under consideration to make sure soft-quality, dangerous names (sometimes known as worth traps) are filtered out. On the second step, a possible constituent faces a margin of security take a look at, with three elements examined, specifically “a large low cost to a conservative valuation,” stability sheet resilience, and free money move. On the ultimate step, forensic accounting methods are utilized as the extra high quality display screen. 100 most resilient names that efficiently handed each take a look at be a part of the index, with constituent weight capped at 1%. Importantly, BDCs can’t compete for a spot in it. It’s price noting that though there’s “a buffer for sure standards” that ought to preserve turnover at bay as mentioned within the prospectus, the metric continues to be slightly excessive at 119%, which is a drag on the fund’s Quant Threat grade.

What optimists say

Exemplary priced portfolio for fervent supporters of worth investing philosophy

One of many main points for maximalist worth buyers searching for pure-play small-cap portfolios is that the majority ETFs that ought to assist them of their pursuits have too giant publicity to the mid-cap universe. I must also comment that at occasions, they even should enterprise into the micro-cap ETFs, thus probably including far more threat as micro-size names are exceedingly unstable and sometimes with meaningfully softer high quality and a plethora of different points.

Fortunately, this isn’t the case with DEEP, which grossly succeeded in its effort to distill a really small-cap portfolio, that includes the weighted-average market capitalization of $942.6 million, with the median at $768.5 million as per my calculations primarily based on June 8 knowledge, though it does have modest publicity (5.7%) to mid caps (lower than $2 billion in market cap) and micro-caps, or these valued at lower than $300 million (5.9%). An identical level was expressed by SA contributor Kurtis Hemmerling within the December 2022 article on DEEP, the place Mr. Hemmerling supplied a superb dialogue of “the dimensions premium” and the failings of the market-cap-weighted funds just like the Vanguard Small-Cap Worth ETF (VBR).

Beneath is the WA market caps of some small-size performs I coated up to now on Searching for Alpha, primarily based on the info from ETF.com (apart from DEEP); IWC was added for higher context.

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Clearly, the Roundhill ETF has the smallest WA MC on this cohort (apart from the micro-cap play); on the identical time, the funds like CALF, IJR, and IWN, and so forth. are clearly tilted in the direction of mid caps and thus wouldn’t attraction to small cap type maximalists.

Subsequent, DEEP additionally has sturdy valuation traits as proven under. Crucial truth is that just about 60% of its holdings have a B- Quant Valuation grade or larger, whereas these seemingly overpriced account for lower than 10%. My expensive readers could notice right here that once I coated SVAL in February 2022, I wrote that “…the load of shares with at the least a B- score doesn’t exceed 56% [of the fund’s net assets], which isn’t very best for a price ETF.” I’ve an analogous opinion on DEEP (I would favor a bigger share), however nuance right here is that the SVAL fund was burdened by low-quality shares again then, whereas the Roundhill ETF will not be.

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Computed by the writer utilizing knowledge from Searching for Alpha

Efficiency for the reason that technique change has been sturdy sufficient

As it’s mentioned within the prospectus, the index methodology was reoriented in the direction of small caps “efficient October 23, 2020.” So, I opted for the November 2020 – Could 2023 interval to investigate. IWC and IVV have been added for higher context.

Right here, DEEP delivered pretty spectacular outcomes, beating most of names within the chosen small-cap worth cohort and likewise besting IVV, with a modest normal deviation, so its risk-adjusted returns (Sharpe and Sortino ratios) are additionally a constructive shock. Importantly, this efficiency was delivered even regardless of the ETF’s burdensome 80 bps expense ratio.

High quality is generally sound

As illustrated by the metrics under, DEEP has a reasonably sturdy high quality.

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Nevertheless, on the adverse facet, ~6.9% of the web property are allotted to eight holdings with adverse working money flows, which is an disagreeable shock contemplating DEEP’s give attention to FCF talked about above.

What skeptics say

Lackluster development publicity reveals margin compression points beneath the floor

The vital drawback with worth methods is that they should sacrifice one thing since there’s all the time (largely) a purpose behind an organization’s engaging valuation, with the highest culprits being both profitability or development considerations. Within the case of DEEP, that is primarily poor development, with just a few minor high quality nuances to dislike. Extra particularly, my calculations primarily based on pundits’ estimates present its weighted-average ahead income development charge at only one.4%, with EPS rising at a glacial tempo and EBITDA even contracting. This can be a disappointment.

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Small AUM, liquidity dangers

One other threat is that DEEP’s AUM is at solely $38.5 million. This is likely one of the explanation why it has the worst liquidity traits (small AUM, low volumes) within the peer group of the Small Worth ETF sub-class encompassing 33 names.

A couple of closing remarks

As a fervent supporter of quality-conscious worth methods, I used to be impressed by DEEP’s fairness combine. The fund has clearly delivered on its promise, with largely sturdy high quality and the cohort-leading efficiency since a serious turning level in its historical past in October 2020. Nevertheless, liquidity and AUM issues shouldn’t be ignored. Its development profile additionally doesn’t attraction to me, whereas there’s a hidden margin contraction difficulty. In sum, I go for a Maintain score.