Skip Reddit, check out the iShares small cap ETF: Strategist

There are a lot of ways to evaluate whether or not an asset is worth adding to your portfolio. One thing to look at is valuation. In Monday's edition of Good Buy or Goodbye, Public Ventures President and Chief Market Strategist Lou Basenese explains why he likes iShares Russell 2000 ETF (IWM) and is avoiding Reddit (RDDT), based in part on their valuations.

The iShares Russell 2000 ETF is "a great way to play the whole basket of small-cap stocks," Basenese says. He also likes the ETF's technicals and says the "setup's right" for small caps to see some big gains. Basenese does, however, caution that higher-for-longer interest rates could be bad for small caps if they go on for too long.

One stock Basenese is skipping is Reddit. Basenese thinks the company is going to struggle to turn a profit. He also doesn't like that Reddit doesn't really own any patents and he thinks the stock is overvalued.

For more expert insight and the latest market action, click here to watch this full episode of Market Domination and here for more Good Buy or Goodbye.

Editor's note: This article was written by Stephanie Mikulich.

Video transcript

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JULIE HYMAN: It's a big, noisy universe of stocks out there. Welcome to Good Buy or Goodbye. Our goal to help cut through that noise to navigate the best moves for your portfolio.

Today, we're breaking down investing plays when looking at valuations. Let's bring back in Lou Basenese, Public Ventures President and Chief Market Strategist.

LOU BASENESE: Good to see you again.

JULIE HYMAN: Hello again.

LOU BASENESE: Long time.

JULIE HYMAN: exactly. So let's get straight to your buy here. It's the iShares Russell 2000 ETF, also known as the IWM. We've already seen a pretty good climb here thus far this year. So, let's get into it here. I mean, that's come after underperformance.

LOU BASENESE: Yeah, tremendous underperformance. I mean, do your own diligence here, but this is a great way to play the whole basket of small-cap stocks. You saw on the chart there had a historic rebound off the October lows is now trading in line with large caps since that time, which has been something that hasn't happened for a really long time. It's breaking out from that perspective. So both up from the bottoms large cap, small caps about 25%.

JULIE HYMAN: So dig into that a little bit more in terms of technically what you're seeing there and what it signals.

LOU BASENESE: Yeah, I'm usually a fundamentals-first guy, but you have to pay attention to the technicals. And when you look at it, all the technicals suggest that this price action is going to continue. So you've got the index itself trading above the 50 and 200-day moving averages. A lot of components in there are from the biotech space. So we're seeing a rebound in biotech that's getting captured here in IWM as well.

JULIE HYMAN: And then finally and just getting to how it's priced versus its history. And for that, we actually have a chart we want to look at that illustrates this a little bit further. So, just to show people what we're looking at here, the S&P 500 PE is in purple. The Russell 2000 PE is in blue. And then, these dotted lines represent their averages.

LOU BASENESE: Their long-term averages. And you see, it's kind of like a gator's mouth opening up. And I'm a UF alum, so I'll just go with the Gator chomp. But what we see is a reversion to the mean here.

So, if you're looking to rotate out of expensive things and buy cheaper ones, small caps represent that. And if we look historically when they've rallied the most coming off of these big disconnects, you've seen gains in excess of 100%, 200%, 300%, and multi-year runs. So not guaranteeing or saying that's going to happen this time, but the setups right. It's compelling, and a lot of people are starting to finally pay attention.

JULIE HYMAN: Yeah, certainly, we've talked to a lot of other investors who like small caps for at this point in the economic cycle as well.

LOU BASENESE: Right.

JULIE HYMAN: That said, it's not without risk. As you know, we always like to talk about what's the potential risk here and it's that interest rates are not really coming down.

LOU BASENESE: Yeah, they haven't come down yet. So you said it, economic cycles have a big impact on small caps. So if we see some jobs data that convinces the Fed to hold rates higher for longer or God forbid, actually inflation picks up again and re accelerates, and the Fed thinks about raising rates again, that would put a damper on this rally for sure because small caps tend to be the most sensitive to economic changes.

JULIE HYMAN: Gotcha. And do you have a position in small caps?

LOU BASENESE: I do have. I personally have a position. Family has a position. Our firm does not. We don't do any banking for an ETF.

JULIE HYMAN: All right, let's get to your goodbye out of here and this one is Reddit, which is really interesting. This looks like a long-term chart but it's not because Reddit just went public, had a spike, but then has since come back down. So what's going on here? You don't think they're going to make any money?

LOU BASENESE: No. I mean, 19 years running and not a single profit. They've got over $800 million in revenue. Look, when you buy any company, it's for the future profit potential, and I don't believe there's any here, and the history proves that out. So, I got a long way to go to turn that corner. 90 million in losses in the last year on $804 million in revenue and tons of R&D spending.

JULIE HYMAN: Now it's interesting your next point here because you point out that they don't hold any patents. Now Reddit would probably argue and has argued that it's the community that they've built.

LOU BASENESE: Of course.

JULIE HYMAN: That that's where the value lies.

LOU BASENESE: When you don't have patents, you talk about other things. Look over here, not at the patents. But if you look at Snap, what's forever doomed Snap from ever catching up to Meta is the fact that Snap never had real patents on their portfolio, whereas Meta has tremendous patent portfolio, and that's allowed Meta to rip off anything Snap innervates and implement it and they have a larger network.

So Reddit suffers from the same fate. In fact, they're actually being challenged by Nokia on some of their IP that they may be infringing upon. They have one patent application. That's really not going to get them anywhere. So, in my view and our firm's view, you have to have the patents to own the marketplace, and they just don't have anything right now.

JULIE HYMAN: Interesting. All right, and let's talk about the valuation as well. You say it's extremely overvalued, and let's compare it to some of the peers. You mentioned Snap a moment ago, so if you're looking at price-to-sales ratios, which if you're not making any money, you have to look at a price-to-sales ratio.

LOU BASENESE: That's right, yeah. There's no earnings and compared to earnings multiples. The only thing that would be more expensive here would be Truth Social and DJT. So we're looking here that Reddit is trading on par at like a nine times price to sales ratio, which is on par with Meta.

And there's worlds of differences. 3 billion active users. And under 100 million. Wildly profitable, no profits. Even if you put it in a class, Pinterest is the most direct comparable, still can't stack up on any level from a price to sales, profitability, and average revenue per user. So, I think Reddit is coming into a crowded space without very much to distinguish itself from the rest.

JULIE HYMAN: Let's talk about the one thing that Reddit has really talked about as its selling point here besides the community thing that could be the potential fly in the ointment for your bear case. And that's the, you know, kind of selling their data to train AI.

LOU BASENESE: Yeah, look, I've been wrong before. So this could be the reason I would be wrong. A $60 billion deal with Google for AI services it's a fractional amount of revenue. But if everyone latches on to this, we saw this through the COVID days, it becomes a meme stock. Everyone gets behind it. They don't invest in the fundamentals. They invest in the hype.

That's what could work against you here.

JULIE HYMAN: Gotcha. And do you have any position in Reddit?

LOU BASENESE: No positions in Reddit.

JULIE HYMAN: OK, Gotcha. So, let's summarize what you are telling people, Lou. You're saying buy that iShares Russell 2000 ETF. Small caps, you say, are now trading as well as the large caps. They're fundamentally compelling and even more gains could come if you look at history as well.

On the other side you say stay away from Reddit. It is extremely overvalued, has nearly no chance of ever making any money, and you say it's doomed without patents. We'll see what happens. Lou, thank you so much.

LOU BASENESE: Thank you.

JULIE HYMAN: Really appreciate it.

LOU BASENESE: Appreciate it.

JULIE HYMAN: And thank you so much for watching Good Buy or Goodbye. We'll be bringing you new episodes three times a week at 3:30 PM Eastern.