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Summary I compared a highly diversified small-cap ETF with an Internet-based ETF. The Internet has not finished permeating our lives, yet we have no need to fear another Internet stock bubble. Going forward, a portfolio or ETF of Internet stocks should outperform both the market and small-cap growth stocks. Source: Wikipedia Commons Through my daily random analyses of stock prices, correlations, and whatnot with R software, I occasionally find something interesting. I especially enjoy looking for patterns in ETFs, as such patterns can give us an idea of where the economy is at and headed. Today I was looking at how Internet-based companies have performed in respect to other industries. Let’s start with the facts: Some investors like small-cap stocks in developed countries because of the huge upside associated with growing companies. Small-cap stocks of developed countries grow in strong economies with few restrictions on business. This makes them good stocks for speculation and for diversification into the “growth stock” sector. However, in these countries, many small-cap companies are heavily reliant on the Internet to run their businesses. In contrast to large-cap stocks that began prior to the time of the Internet, many of these small-cap companies would likely go under if they lost the power of the Internet to transcend geographics, save on communication costs, and monitor the habits and demographics of their clients. When I began looking into the correlation between Internet-based companies and small-cap stocks I found – unsurprisingly – that said correlation was quite high. Of course, not all small-cap stocks are Internet companies. However enough are to show a strong correlation between the two industries. In my analysis, I looked at the following ETFs: PowerShares NASDAQ Internet ETF (NASDAQ: PNQI ) iShares MSCI EAFE Small-Cap (NYSEARCA: SCZ ) The first is a portfolio of NASDAQ Internet companies. The included companies are large-cap growth stocks. The second is a portfolio of small-cap companies in developed countries, mainly the Europe and Japan. After importing the data from these two ETFs, I checked the correlation coefficient: an astounding 0.97! Yes, some of this correlation is due to an overall correlation with the general market, but below I’ll be showing some charts that show how these two ETFs differ from the market as a whole. Also realize that these portfolios have little overlap in actual securities: One is U.S.-centric (over 80%); the holds less than 1% of U.S. stocks. One is small-cap; the other large-cap. One is growth-only; the other mixes in some value stocks (I’m speaking of SCZ). Yet these two ETFs are almost perfectly correlated! It’s as if the NASDAQ Internet companies are working in tandem with small-cap companies. Or perhaps small-cap companies are gaining their business from NASDAQ Internet companies? Instead of speculating, let’s take a look at how the stocks move in respect to each other. I want to do this for multiple periods. I’ll explain why in a second: The Past Year: (click to enlarge) When you look at the first chart, it looks like PNQI and SCZ are pretty similar. It might appear that PNQI has done better in the past few months. But overall, these two ETFs look like the perform roughly at the same quality. Since the Existence of Both ETFs: (click to enlarge) Now we see a significant difference. Though these two ETFs are highly correlated, PNQI outperforms SCZ. That is, if you switched out small-cap growth stocks for large-cap Internet companies, you’d have realized a gain of over 200%. Sticking with the small-cap “growth” stocks, which are supposed to outperform during a bull market (the time period we are currently looking at), you would have underperformed – the SPDR S&P 500 ETF (NYSEARCA: SPY ), during this time, realized gains of 50%, while SCZ only grew 10%. The Past 3 Months: (click to enlarge) So here’s where things get interesting. While the previous two charts showed PNQI to be the better choice, in this chart, we see SCZ higher than PNQI. Notice that both these ETFs are in negative territory, so one explanation might be that PNQI is a risky ETF. However, to say that PNQI is risky simply not true, unless you believe that SPY is risky: both ETFs are down 4% in the past three months. Yet as we have seen in the chart going back to 2008, PNQI has outperformed SPY by 150%. That is, PNQI appears to have much more upside than both SCZ and SPY yet the downside is the same as that of SPY. Is SCZ an Outlier? To check if SCZ is an outlier, I checked other EAFE funds’ correlations to both SCZ and PNQI. The quick answer is that SCZ is not an outlier; the result holds for other EAFE small-cap and growth funds. For instance, SCZ and the iShares MSCI EAFE Growth ETF (NYSEARCA: EFG ) are 99% correlated. EFG is also 94% correlated with PNQI, showing a unique connection with EAFE small cap companies and Internet companies. Likewise, Vanguard MSCI EAFE ETF (NYSEARCA: VEA ) shows 0.99 and 0.94 correlations to SCZ and PNQI, respectively. The Future of Internet Companies The Internet bubble of the 90s taught us to be weary of investing too much in Internet-based companies. But unlike other bubbles (e.g., the housing bubble), we were dealing with a new invention in the 90s (Internet-based business). Today, we have a much better understanding of how Internet companies work. Thus, I don’t see PNQI’s extreme returns as a bubble but as the result of a legitimately good business model: putting your money where business is booming – online. The Internet has and will continue to permeate our lives (how are you reading this article right now?). And the last three months has shown that Internet companies don’t hurt more than the general market when a correction comes. Internet traffic is growing and bandwidth requirements are increasing for current users. One reason for this is the transition to video, which comes from two sources: A preference for consuming content in video form. A shift to streaming entertainment (e.g., Netflix (NASDAQ: NFLX ), which PNQI holds). By 2017, 70% of Internet traffic will be directed toward video, according to Cisco. The Internet is also changing how people shop. Today, consumers are using an omnichannel shopping method, which essentially means that they are browsing multiple sites at once to find the best deal. Such an activity would have been time-consuming and gas-consuming in the era where one had to drive store-to-store for price comparisons. Look at some of the holdings in PNQI to appreciate the fund’s appreciation of the growth of the omnichannel shopping preference: Amazon (NASDAQ: AMZN ) Priceline (NASDAQ: PCLN ) EBay (NASDAQ: EBAY ) Expedia (NASDAQ: EXPE ) Tripadvisor (NASDAQ: TRIP ) This is where the real growth is at. PNQI also has holdings in Chinese Internet companies, such as Baidu (NASDAQ: BIDU ), which PNQI first bought in 2008. To this, they’ve added other important Chinese Internet stocks, such as… JD.com (NASDAQ: JD ), an online “mall” for electronic products (omnichannel shopping). Ctrip.com (NASDAQ: CTRP ), an airline and hotel booking service (omnichannel shopping). NetEase (NASDAQ: NTES ), an IT company known for being the largest email service provider in China. …and anything else they can get their hands on via NASDAQ. Yet, investors looking for “growth” often turn to these investing concepts: “Invest in small-cap stocks.” “Invest in foreign countries; U.S. stocks are overpriced.” “Diversify among many growth stocks.” Investors agreeing with such statements would find SCZ the perfect ETF. SCZ does not hold more than 1% of its portfolio in a single stock – the maximum weight to any given stock is less than half a percent. And SCZ’s holdings are all over the place: Switzerland, the U.K., Japan… In contrast, PNQI attaches close to 10% of its portfolio. AMZN, PCLN, Facebook (NASDAQ: FB ), and Alphabet Inc (NASDAQ: GOOG ), all individually occupy more than 8% of the PNQI portfolio. PNQI also certainly doesn’t see U.S. stocks as overbought, as the vast majority of its portfolio is in the U.S. In other words, PNQI is virtually the antithesis of SCZ. Conclusion The two ETFs we just looked at correlate… but only one consistently outperforms. And I believe that PNQI will continue to outperform both SCZ and SPY, at least until the next big thing (can something possibly surpass the Internet?). We are not repeating the bubble of the 90s because the Internet is no longer a mere novelty but an integral part of culture in the developed world. The demand for the stocks PNQI holds will increase as long as the companies behind those stocks are continually making improvements in our lives (or finding ways to addict us to their products – FB, I’m looking at you). In addition, PNQI’s exposure to the Chinese Internet market shows a stark contrast to what I see in SCZ management sa being more of a “spray-and-pray” shotgun approach to a growth portfolio: Invest a little in everything and hope we keep attracting clients; no portfolio manager every gets fired for diversifying. I am assigning a strong buy rating for PNQI going into 2016 and an underperformer rating to SCZ. I would recommend, based on the most recent chart comparing PNQI to SCZ, that SCZ holders sell their shares now, while SCZ is above both the market and PNQI. Once sold, take the capital that was in SCZ and put it in PNQI, while it’s at a relative discount. Request a Statistical Study If you would like for me to run a statistical study on a specific aspect of a specific stock, commodity, or market, just request so in the comments section below. Alternatively, send me a message or email.