By Christopher Gannatti
2013 was a very strong year for U.S. small-cap stocks. However, as is often the case, with great performance comes concern about valuation.
Instead of being concerned with valuations in U.S. small caps, we encourage investors to consider diversifying their small-cap allocations around the world. We believe that important valuation opportunities still abound, and we are particularly excited about what we see in developed international equities.
Why Allocate to Small-Cap Stocks?
Stepping back, it's critical to address why people should think about small-cap stocks in the first place. Ultimately, small caps are able to be the most sensitive to incremental changes in economic growth expectations. One reason for this regards their weight in what we call "cyclical sectors."
- The WisdomTree International SmallCap Dividend Index (WT Int. Small Dividends) had more than 84% of its weight in cyclical sectors as of July 25, 2014.
- As a point of reference, the WisdomTree International LargeCap Dividend Index had only about 61% of its weight in cyclical sectors at that time.
- The same phenomenon occurs when looking at the MSCI EAFE Index, predominantly a large-cap exposure (70% exposure to cyclical sectors), versus the MSCI EAFE Small-Cap Index (84% exposure to cyclical sectors).
Exposure to incremental increases in economic growth expectations is therefore an important element when considering small-cap stocks.
Mitigating Risk in Small-Cap Stock Exposures
Where the discussion gets interesting is when determining how to generate attractive risk-adjusted performance within small-cap stocks, as the economic sensitivity that makes small caps attractive can also at times lead to volatility. From our perspective, focusing on dividends is of particular interest. As of July 25, 2014, approximately 85% of the weight of the MSCI EAFE Small Cap Index was in stocks that had paid at least one dividend over the prior 12 months, telling us that the landscape of small-cap dividend payers provides a rich hunting ground.
Has a dividend-focused approach to developed international small caps actually helped to balance the growth sensitivity of small-cap stocks with their potential for increased volatility?
Putting Developed International Small-Cap Dividend Payers to the Test
Dividend Payers Outperform: Over the three-year, five-year and since-inception periods, WT Int. Small Dividends outperformed the MSCI EAFE Small Cap Index. In a strong market during the one-year time frame, the dividend payers definitely kept pace-a feat we believe impressive because dividend-focused strategies frequently do not capture the full upward moves of bull markets.
Dividend Payers Lower Risk across All Periods: One way to consider risk is through the beta statistic, a measure of the relative volatility between two indexes. The MSCI EAFE Small Cap Index, serving as the benchmark in this case, will therefore have a beta of 1.00 in every period. Since WT Int. Small Dividends is less than 1.00 over every period shown, this indicates that risk was reduced over these periods.
For those thinking in more absolute terms, WT Int. Small Dividends also had a lower standard deviation than MSCI EAFE Small Cap Index over each of the periods shown.
While we believe the historical track record is impressive, past performance is just that-in the past. To really put these results in context, it's important to understand that the single most important element of WT Int. Small Dividends is its annual rebalance. Simply put:
- Firms Rewarded with Greater Weight: Typically, these are firms where share-price performance has been lackluster, but dividends have remained stable or grown.
- Firms Punished with Lower Weight: Typically, these are firms where share-price performance has been very strong, but dividends-in other words, fundamentals-have not appreciated commensurately.
The fact is that the top-performing stocks of today may not be poised to become the key drivers of performance tomorrow-especially after the strong year that we've just seen. Historically, WT Int. Small Dividends has undergone eight rebalances.
Dividend Yield Has Tended to Increase: On average, the Index dividend yield has increased nearly 23%. In essence, this is a natural consequence of the dividend-focused methodology.
Price-to-Earnings (P/E) Ratio Has Tended to Decrease: On average, the Index P/E ratio has tended to decrease by about 12%.
Important Risks Related to this Article
Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development.
Diversification does not eliminate the risk of experiencing investment losses.
Dividends are not guaranteed and a company's future ability to pay dividends may be limited. A company currently paying dividends may cease paying dividends at any time.
Christopher Gannatti, Associate Director of Research
Christopher Gannatti began at WisdomTree as a Research Analyst in December 2010, working directly with Jeremy Schwartz, CFA®, Director of Research. He is involved in creating and communicating WisdomTree's thoughts on the markets, as well as analyzing existing strategies and developing new approaches. Christopher came to WisdomTree from Lord Abbett, where he worked for four and a half years as a Regional Consultant.