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

Introduction

We wrote an article on Schwab U.S. Mid-Cap ETF (NYSEARCA:SCHM) in May 2023. At that time, we noticed that earnings and revenues revision for mid-cap stocks was far from over and suggested investors to patiently wait on the sidelines. It has been over a year since we last covered SCHM, we are now in a very different macroeconomic environment. Therefore, we think it is time for us to examine the fund again and provide our analysis and recommendations.

ETF Overview

SCHM has a portfolio of nearly 500 U.S. mid-cap stocks. The fund has a low expense ratio of only 0.04%. Other funds such as Vanguard S&P Mid-Cap 400 ETF (IVOO) charges slightly higher ratio of 0.10%. The fund has not done well in the past few years due to an elevated rate environment. However, as inflation eases, an eventual rate cut cycle should create a much more favorable environment, and SCHM’s exposure to cyclical sectors will benefit from this shift. In fact, significant earnings growth can be expected in the next few years. With an inexpensive valuation, SCHM deserves a buy-rating.

Fund Analysis

SCHM has not done well in the past two years

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

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

Sector allocation: a pivot towards cyclical sectors

To evaluate the outlook of SCHM, we will need to first look at SCHM’s sector allocation. As can be seen from the table below, SCHM has a high exposure to cyclical sectors. These sectors (basic materials, consumer cyclical, financial services, and real estate sectors) represent nearly 40.2% of the total portfolio. As we know, cyclical sectors are highly sensitive to business cycle peaks and troughs. Therefore, we expect SCHM’s fund price to have higher correlation to different cycles of the economy than other funds that have lower exposure to these sectors. In other words, if the economy is heading for recession, SCHM will be impacted more severely. On the other hand, SCHM may have the potential to outperform, especially when the macroeconomic environment is turning more favorable.

Macroeconomic environment is becoming favorable for mid-cap stocks

Fortunately, we think the macroeconomic environment is turning more favorable especially for mid-cap stocks. As the chart below illustrates, the U.S. core inflation rate continued its downward trajectory in August 2024, delivering an annual growth rate of only 3.2%, much lower than the peak of 6.6% reached in September 2022. The easing inflation has now opened the door for the Federal Reserve to eventually begin its rate decline cycle.

Higher interest rate typically causes more pain to mid-cap stocks than 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 as it increases borrowing costs, and reduces business activities. Fortunately, the Federal Reserve’s possible rate cut cycle will quickly ease the pressure that many of these mid-cap stocks are facing.

Below is the chart that shows the forward profit margin of the S&P 400 mid-cap index in the past 20 years. Although stocks in this index is not exactly the same as SCHM’s portfolio, both consists of mid-cap stocks and have similar performance in the past. Therefore, we expect profit margin trend to be very similar. As the chart below shows, in much of 2022 and early 2023, forward profit margin declined by about 1 percentage point due to higher inflation and the Federal Reserve’s tightening monetary policy. Fortunately, we think the Federal Reserve’s eventual shift towards an easing policy will help further improve forward margins of these mid-cap stocks.

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

As the macroeconomic environment improves due to easing inflation and the beginning of a possible rate cut cycle, mid-cap stocks in SCHM’s portfolio should experience outperformance thanks to its higher exposure to cyclical sectors. Below is a table that compares the earnings growth forecasts of the S&P 400 mid-cap index with the S&P 500 large-cap index. As can be seen from the table below, consensus earnings growth for the S&P 400 mid-cap index is expected to jump from negative 0.3% in 2024 to 17.1% in 2025 and 15.0% in 2026. In contrast, the S&P 500 index is only expected to deliver earnings growth rates of 15.3% in 2025 and 12.8% in 2026. Based on this comparison, we have good confidence to see SCHM outperforming the S&P 500 index in the next two years.

Click to enlarge

Source: Yardeni Research, Created by author

Inexpensive valuation

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

Risk to consider: Inflation flare up

Although we are seeing signs of inflation easing considerably, taming inflation is not an easy task. This is because inflation has a spiraling effect. For example, wage increase often result in price increases, and this will further result in demand for wage to increase. This was the reason why the Federal Reserve needs to keep its rate elevated for two years and not to rush to lower the rate early. They knew that rate cuts, if done too early and too aggressive, has the potential to cause inflation to flare up again. Therefore, investors should not assume the Federal Reserve will quickly lower the rate to a level back in 2020.

Investor Takeaway

SCHM’s earnings growth outlook is improving in 2025 and 2026 thanks to better macroeconomic environment. The fund should benefit from the Federal Reserve’s eventual rate-cut cycle. Its valuation is also inexpensive. Therefore, we have a buy-rating on the fund.

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