AAM ETF Insights: The Tortoise Wins

?The Tortoise wins

One of Aesop’s most famous fables is the Tortoise and the Hare. This classic story between a slow-moving turtle and a bragging bunny has helped millions learn the lesson that ‘slow and steady wins the race’. Can this same lesson be applied to the world of investments?

We certainly think so, especially when it comes to investing in small cap growth stocks.

Rapid Growth v. Consistent Growth

If both the hare and the tortoise were small cap growth stocks, the former would be Rapid Growth Ralph and the latter would be Consistent Growth Carl. Many small cap investors are wooed by rapid earnings growth, and therefore, are likely to side with the arrogant and reckless rabbit, Rapid Growth Ralph. Others will side with Consistent Growth Carl and argue that patience and steady growth may unlock better results over the long run. We happen to agree with the latter and here’s why.

MEET SAWS

Let’s explore how a strategy focused on stable earnings growth, lower volatility, and attractive valuations can help investors win the race. Meet AAM’s version of Consistent Growth Carl – AAM Sawgrass U.S. Small Cap Quality Growth ETF (SAWS).

Currently, one of the largest holdings of SAWS is Sterling Infrastructure (STRL)^. Since 2016, the price of STRL has risen from around $6 to well over $100 per share on the heels of a consistent, tortoise-like increase in earnings. This consistent growth has led to a 21x multiplier in less than 9 years.

Now consider CoreCard Corp. (CCRD)^, not a holding of SAWS. Between 2016 and early 2020, the trailing 12-month EPS rate for CCRD shot up from $0.17 to $1.22 per share (Exhibit 1). This kind of rapid growth certainly makes headlines – few things are more exciting than triple-digit growth. As a result, CCRD’s prices went from around $3 to over $50 per share.

What Happened Next is Important.

This Rapid Growth Ralph took a long nap and CCRD’s earnings growth stalled for years before catching up in 2022. The share price, however, continued to decline even as earnings increased. Since then, it has slid both in earnings and share price.

^Holding subject to change and are not recommendations to buy or sell any security. As of 8/30/24, SAWS had a 3.41% allocation to STRL.

Exhibit 1: Historical Price/EPS Growth: STRL/CCRD, respectively. As of 7/30/24Source: Portfolio 123; Factset

These two examples highlight a deeper behavioral pitfall of growth investors? – in general, they misprice growth based on recency. Stocks with very high recent growth can often be poor investments because investors become overly bullish, and that bullishness is then priced into the stock.

High Sales Growth Rate / Low Returns

High sales growth, while an important metric providing indications of a company’s health, does not always correlate to positive stock market performance. The following chart shows 20 sub-portfolios in a small-cap universe of stocks based on the 3-year trailing sales growth rate. The bar at the left is the compound annual growth rate (CAGR ) of the Russell 2000 Growth, since 1999. Bucket #1 represents the lowest growth portfolio and Bucket #20 represents the highest growth portfolio (see Exhibit 2).

Exhibit 2: Quantile Returns of 3-Yr Sales Growth (1999-Present)

Source: Portfolio 123; Factset

Two observations that stand out include:

1. The highest growth portfolio has the lowest returns, even lower than the lowest growth portfolio;

2. The steady and consistent growth of Bucket 10 portfolio? demonstrated the highest returns over time.*

Low Volatility Anomaly

Aesop’s fable isn’t finished giving us investment lessons. The tortoise and the hare can also represent share price returns. Some stocks, like the hare, are volatile and move rapidly. Other stocks, like the tortoise, move more slowly. Conventional wisdom would tell us that volatile stocks are riskier and therefore they need to produce additional returns to compensate for that risk. Surprisingly, research shows the opposite to be true (see Exhibit 3). The low volatility anomaly is an observation that stocks with less volatility have a tendency to out-perform their higher volatility counterparts. While many explanations have been put forward to explain this anomaly, it most likely comes down to the demand for low-volatility investments by risk conscious investors. This demand may be driven by the protection provided during periods of market drawdowns.

Exhibit 3: Performance of High-Beta v. Low-Beta Stocks (3/31/85 - 12/31/23)*

Source: Factset; Axioma

Conclusion

By combining the low volatility anomaly, with consistent growers and attractive valuations, the AAM Sawgrass U.S. Small Cap Quality Growth ETF (SAWS) may help produce a turtle-like outcome for your portfolio to potentially cross the finish line ahead of the sleeping hares!

For more information on the SAWS, please contact your financial professional or visit us at www.aamlive.com.

This publication is provided for information purposes only. Unless otherwise stated, all information and opinions contained in this publication were produced by Advisors Asset Management, Inc. (AAM) and other sources believed by AAM to be accurate and reliable. Due to rapidly changing market conditions and the complexity of investment decisions, supplemental information and other sources may be required to make informed investment decisions based on your individual investment objectives and best interests. All expressions of opinions are subject to change without notice.

Past performance does not guarantee future results. Investing involves risk, including the possible loss of principal.

The? investment objectives, risks, charges and expenses must be considered carefully before investing. The Fund’s statutory and summary prospectuses contains this and other important information about the investment company, and may be obtained by calling 800.617.0004 or visiting www.aamlive.com. Read it carefully before investing.

Investing involves risk, including the possible loss of principal. Shares of any ETF are bought and sold at market price (not NAV) and may trade at a discount or premium to NAV. Shares are not individually redeemable from the Fund and may only be acquired or redeemed from the fund in creation units. Brokerage commissions will reduce returns. Companies with high yield or payout ratio may underperform other securities in certain market conditions and reduce or discontinue paying dividends entirely while included in the index. The Fund’s return may not match or achieve a high degree of correlation with the return of the underlying Index. Diversification does not assure a profit or protect against a loss in a declining market.

Principal risks of investing in this strategy include stock market risk, management risk, recent market events risk, and large cap company risk. Equity Market Risk: The equity securities held in the Fund’s portfolio may experience sudden, unpredictable drops in value or long periods of decline in value. This may occur because of factors that affect securities markets generally or factors affecting specific issuers, industries, or sectors in which the Fund invests. Common stocks are generally exposed to greater risk than other types of securities, such as preferred stock and debt obligations, because common stockholders generally have inferior rights to receive payment from issuers. Market Capitalization Risk: The Fund invests in small-capitalization companies which may be more vulnerable to adverse issuer, market, political, or economic developments than securities of large-capitalization companies. Smaller-capitalization companies generally trade in lower volumes and are subject to greater and more unpredictable price changes. Growth Investing Risk: Growth style investing may fall out of favor and underperform other styles of investing over any period of time. Certain sectors or growth stocks may shift characteristics over a long market cycle and may not perform in line with stated benchmarks. Companies experiencing high rates of current growth may be more volatile than other types of investments. New Fund Risk: The Fund is a recently organized investment company with no operating history. As a result, prospective investors have no track record or history on which to base their investment decision.

Definitions: Beta is a measure of the volatility, or systematic risk, of a security or a portfolio in comparison to the market as a whole. Cash flow is the net amount of cash and cash-equivalents moving into and out of a business. Compound Annual Growth Rate is the mean annualized growth rate for compounding values over a given time period. Earnings per Share (EPS) is a company’s net income divided by its outstanding shares of common stock.?? Volatility is the frequency and magnitude of price movements in the stock market. Russell 2000 Growth Index measures the performance of the small-cap growth segment of the U.S. equity universe. It is not possible to invest directly in an index.

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