EWUS: I See Challenges For Small-Cap British Stocks (Rating Downgrade) (BATS:EWUS)

Main Thesis & Background

The purpose of this article is to evaluate iShares MSCI United Kingdom Small-Cap ETF (BATS:EWUS) as an investment theme under current market conditions. This is a fund that tracks small-cap U.K. stocks specifically. This differs from the ETFs I usually write about to give my outlook on British companies, which is the iShares MSCI United Kingdom ETF (EWU). EWU, by contrast, has a broader focus and includes mostly large and mid-cap companies – not small-caps.

I wrote about EWUS to give my take on smaller, domestic-oriented British companies roughly a year ago. At that time I saw some value and suggested a buy rating was a reasonable call. In hindsight, performance has been rather disappointing. It has squeezed out a small gain, but that pales in comparison to the swift rebound we have seen in US stocks:

Given this moderate performance I thought it was time to take another look at EWUS and see if a buy rating remains justified. After review, I think the chances of strong gains in the second half of the year are quite low. Broadly speaking, there is merit to British equities – both large-cap and small-caps – due to their below-average valuations. But those valuations exist for some valid reasons and the present headwinds challenge the investment outlook. This is leading me to downgrade my rating to “hold”, and I will explain the rationale behind this decision in more detail below.

Inflation Challenge A Relative Outlier

To begin I want to talk about why someone may even be considering British equities in the first place. Aside from the obvious diversification benefit – which is true for any non-US developed nation – British companies seem generally undervalued against the broader market right now.

If we isolate just large-cap British stocks against their large-cap US counterparts, we see a wide spread right now. In fact, the primary British equity index is at a historic discount compared to the S&P 500 currently:

This is still relevant to EWUS even though this is an ETF that focuses on small-caps because it speaks to why people are even looking across the pond at all. There is inherent value in British equities and that could lead investors to look at the best ways to play it. If one is particularly wanting non-US and small cap exposure, metrics like the one above could suggest EWUS is a reasonable place to start looking. That is because investors would see a similar valuation disparity between EWUS and the broader market as well:

So this tells us British stocks are “cheap”. I took cheap in quotes because everything is relative. What may be expensive in one cycle is cheap in another, but British stocks are relatively cheap compared to the developed world and that could entice value-oriented investors like myself.

The challenge here is that British stocks, both large-cap and small-cap, are cheap for some valid reasons. One item in particular that is impacting the more domestically-oriented small-cap market – and thus EWUS by extension – is inflation within the United Kingdom. While this is (and has been) a pervasive problem across most of the globe for a while, the problem is especially pronounced in the United Kingdom, as shown below:

Clearly, the UK is struggling with getting headline inflation under trouble to a greater degree than other nations. This is pressuring the forward outlook and is a likely reason why investors are unwilling to bid up these shares as aggressively.

This is having a negative two-prong effect on the economy. On the one hand, such stubborn inflation is going to continue to pressure the Bank of England to keep raising benchmark rates. Perhaps even after other central banks (such as the Fed) begin to pause. Further, it is stunting some economic growth, resulting in a net negative situation where growth is weaker than other countries yet, because of inflation, the central bank’s path may wind up being more hawkish. For perspective, consider that the UK economy is the only member of the G7 that has not yet recovered completely to pre-Covid growth figures:

I am not bringing up all these points to be alarmist. Rather, I am trying to help justify why British stocks are as cheap as they are. If these stocks were cheap and everything was rosy – it would be a screaming buy signal for funds like EWU or EWUS. But, on the contrast, these shares are trading at below-average valuations because there are primary macro-concerns. Whether or not these clouds will clear in the near term is up for each individual to decide. Similar to whether or not the risks are worth the potential reward. But is clear to me at the very least that British shares are cheap for valid reasons.

US Rally Could Have Legs

The next topic to discuss is how things are faring here at home. This is important to me because I look to non-US developed holdings primarily for diversification. I tend to have a permanent allocation to Canada, Britain, and Ireland all the time – but I increase and decrease that allocation based on prevailing circumstances. Conventional wisdom indicates that with the strong gains by the major US indices in 2023, the time is ripe for re-positioning:

As you can see, domestic (for US-based investors) equities have moved higher and that stands in contrast with EWUS, which is the purpose is this review. This performance divergence is something I noticed that suggested I should be considering EWUS as a value play. After all, if US stocks are getting ahead of themselves, than looking for more beaten down sectors like small-cap British stocks (through EWUS) could be a smart play.

The issue I have with that conventional logic is that US stocks seem to be well supported at the moment. While the rally had been contained to a handful of large-cap Tech firms initially, recent months have shown a broadening of stock market leadership. This has started to include a wider variety of stocks, which was something investors were hoping for:

The conclusion I draw here is that moving out of US stocks and in to UK stocks may not even be the right move in this climate. Of course, the diversification benefit always exists and it does now too. So weigh that carefully. But for one anticipating a correction in US stocks that will simultaneously benefit small-cap UK stocks (and therefore EWUS), the time may not be right. The US market rally appears to have legs as more companies/stocks are beginning to participate in it. That is a bullish signal and makes the argument for EWUS more difficult to make at the moment.

EWUS Short On Energy Exposure

My next topic takes a look at what EWUS doesn’t have. I bring this up because I am an Energy sector bull at the moment – owning both the Vanguard Energy ETF (VDE) and the iShares Global Energy ETF (IXC). This is an area that has started to gather steam recently, driven by rising crude oil prices. In a nutshell, this is a trend that is likely to continue in the second half of the year as the market continues to face a oil shortage:

This is important because internationally focused areas of the market – such as the Energy sector – have been recovering consistently with these rising oil and other commodity prices. That has been beneficial and is key to why the sector has been a leader over the last few months.

The problem as it relates to this article is that EWUS does not own very much exposure to this area, as shown below:

Of course this is just one theme and may not be relevant for every reader. Perhaps you don’t want Energy and/or you already have enough. That is a fair counter-point. But what I am suggesting is Energy is a top performing sector right now for good reason and – if one did want British exposure – the large cap UK ETF from iShares (EWU) would probably be the bigger option:

What I am trying to get across is readers need to be very clear on the why behind why they want this exposure. Do they want small-cap UK exposure specifically and, if yes, what are they hoping to get out of it? If they want sectors with recent momentum, they won’t really find it here. But if there are other reasons – such as low valuations and consumer/industrial exposure – then this could fit the bill. It all depends on one’s individual perspective.

Consumer Currently A Bright Spot

Through this review my tone has been lukewarm at best. I needed it to be in order to explain the rationale for my rating downgrade. But readers should note I am not overly “bearish” on this fund. EWUS has indeed seen some recent weakness but its valuation is a supporting factor that should limit further losses. While no guarantee, it is hard for me to be a real bear with so much downside already baked in.

Further, the graphic in the prior paragraph illustrated that EWUS is long the British consumer. That makes sense since small-cap companies tend to be more domestically oriented. That means they will rise and fall often along with the fortunes of British households. In this vein, there are some reasons to be optimistic. A key reason is that wage growth has been strong in the UK – both in isolation and compared to other developed regions:

This could very well help support domestic companies within Britain in the months ahead, suggesting the relative discount for these shares is a buying opportunity. But the challenge to me is that if wage growth remains high, so too will inflation, fueling more action by the Bank of England will may counter-balance some of the positive effect. This push-pull dynamic is central to why I see “hold” as the appropriate choice.

Bottom-Line

EWUS’ performance over the past year has not been too impressive and that is a story I expect to continue as we wrap up 2023. There are some merits to owning or buying it, such as a resilient UK consumer and a dirt cheap valuation. But that valuation metric is similar for large-cap British companies too and I see that as a more viable option given the greater Energy sector exposure large-caps offer.

Further, the US stock market (as measured by the S&P 500) has a lot of momentum and greater participation outside of the Big Tech firms. These are bullish signals that may warrant a higher allocation closer to home rather than overseas. What this all adds up to for me is a neutral outlook and that is why I am downgrading my rating on EWUS at this time.