SCHM ETF: Income Growth Accelerating Through 2026 (NYSEARCA:SCHM)

Introduction

I wrote an article about the Schwab US Mid-Cap ETF (NYSEARCA:SCHM) in May 2023. At that time, we noted that the review of earnings and revenue for mid-cap stocks was far from over and suggested that investors wait patiently margin. It has been over a year since we last covered SCHM, we are now in a very different macroeconomic environment. Therefore, we believe it is time to re-examine the fund and provide our analysis and recommendations.

Overview of ETFs

SCHM has a portfolio of nearly 500 US mid-cap stocks. The fund has a low expense ratio of just 0.04%. Other funds, such as the Vanguard S&P Mid-Cap 400 ETF (IVOO) charge a slightly higher ratio of 0.10%. The fund has not performed well in recent years due to a high rate environment. However, as inflation falls, an eventual rate the down cycle should create a much more favorable environment and SCHM’s exposure to cyclical sectors will benefit from this change. In fact, one can expect a significant increase in earnings over the next few years. With a cheap valuation, SCHM deserves a buy rating.

Background analysis

SCHM has not fared well in the last two years

Let’s first see how SCHM has performed in recent years. Similar to the broader market, the SCHM fund’s price went through a bearish period for most of 2022, primarily due to the Federal Reserve’s aggressive rate hikes to tame high inflation. As the chart below illustrates, the SCHM fund price has typically outperformed the S&P 500 large-cap stocks in the broader market decline in the past. We can see this underperformance in the 2020 recession and the broader market decline in 2022.

Fortunately, since the broader market hit its cyclical low in October 2022, the price of the SCHM fund has gradually recovered. Although the SCHM fund’s price has yet to peak in 2021, it delivered a solid total return of nearly 36%, but lagged behind the S&P 500’s 61.8% performance.

Sector Allocation: A Pivot to Cyclical Sectors

To assess SCHM’s prospects, we will first need to look at the allocation to the SCHM sector. As can be seen from the table below, SCHM has a high exposure to cyclical sectors. These sectors (basic materials, cyclical consumption, financial services and real estate) represent almost 40.2% of the total portfolio. As we know, cyclical sectors are very sensitive to the peaks and troughs of the business cycle. Therefore, we expect the price of the SCHM fund to have a higher correlation with various cycles of the economy than other funds that have less exposure to these sectors. In other words, if the economy heads into recession, the SCHM will be hit harder. On the other hand, SCHM may have the potential to outperform, especially when the macroeconomic environment becomes more favorable.

The macroeconomic environment is turning favorable for midcap stocks

Fortunately, we believe that the macroeconomic environment is becoming more favorable, especially for mid-cap stocks. As the chart below illustrates, the US core inflation rate continued its downward trajectory in August 2024, delivering an annual growth rate of only 3.2%, well below the 6.6% peak reached in September 2022. Relaxing inflation has now opened the door for the Federal Reserve to finally begin its rate cut cycle.

Higher interest rates usually cause more pain to mid-cap stocks than to large-cap stocks. This is because mid-cap stocks typically have weaker balance sheets and are less established than large-cap stocks. Therefore, higher interest rates can be problematic because they increase borrowing costs and reduce business activities. Fortunately, the Federal Reserve’s possible rate cut cycle will quickly ease the pressure facing many of these mid-cap stocks.

Below is the chart showing the forward profit margin of the S&P 400 mid-cap index over the past 20 years. Although the stocks in this index are not exactly the same as the SCHM portfolio, both are made up of mid-cap stocks and have similar past performances. Therefore, we expect the profit margin trend to be very similar. As the chart below shows, through much of 2022 and into early 2023, the forward profit margin fell by about 1 percentage point due to higher inflation and the Federal Reserve’s tightening monetary policy. Fortunately, we believe that the Federal Reserve’s eventual move toward an easing policy will help further improve forward spreads on these mid-cap stocks.

Growth rates are expected to outpace the S&P 500 index

As the macroeconomic environment improves due to lower inflation and the start of a possible rate cut cycle, mid-cap stocks in the SCHM portfolio should outperform due to greater exposure to cyclical sectors. Below is a table comparing earnings growth forecasts for the mid-cap S&P 400 to the large-cap S&P 500. As can be seen from the table below, consensus earnings growth for the mid-cap S&P 400 is expected to grow from a negative 0.3% in 2024 to 17.1% in 2025 and 15.0% in 2026. In contrast, the S&P 500 is only projected to deliver earnings growth rates of 15.3% in 2025 and 12.8% in 2026. Based on this comparison, we are confident that SCHM will outperform the S&P 500 over the next two years.

Click to enlarge

Source: Yardeni Research, Created by author

Cheap evaluation

The chart below shows the forward P/E ratio of the S&P 400. As can be seen from the chart below, this mid-cap index is currently trading at a forward P/E ratio of 15.4x. Over the past 20 years, the valuation has typically been in the 14x ~ 18x range. The current valuation of 15.4x is slightly below its average of around 16x. Therefore, we believe that SCHM is cheap.

Risk to consider: Inflation has increased

Although we are seeing signs of considerable decline in inflation, taming inflation is not an easy task. This is because inflation has a spiral effect. For example, an increase in wages often leads to an increase in prices, and this will further increase the demand for wages. This was the reason why the Federal Reserve has to keep its rate high for two years and not rush to cut the rate early. They knew that rate cuts, if done too soon and too aggressively, had the potential to cause inflation to flare up again. Therefore, investors should not assume that the Federal Reserve will quickly cut the rate to a level as early as 2020.

Investor Takeaway

SCHM’s earnings growth outlook improves in 2025 and 2026 due to a better macroeconomic environment. The fund should benefit from the Federal Reserve’s eventual rate cut cycle. Its evaluation is also cheap. Therefore, we have a buy rating for the fund.

Additional Disclosure: This is not financial advice and that all financial investments involve risks. Investors are expected to seek professional financial advice before making any investment.