Many market watchers are discussing valuations in small caps, a theme WisdomTree’s research team has been writing about since the start of the year. As the most recent example, Josh Brown, also known as “the Reformed Broker,” tweeted the following on March 25, 2014:

Russell 2000’s PE ratio now at a 40% premium to the total market, not seen since 1979. Spread between small and large PE at a 34 year high.” 1

I generally agree that small caps have been on an unprecedented run, outperforming large caps since 2000, and there will come a time, perhaps soon, when large caps take leadership again.2

But there are also some biases in the Russell 2000 price-to-earnings (P/E) ratio. For instance, over 20% of the Russell 2000 is invested in money-losing companies—that is negative earners—that bias the total P/E ratio upward, as discussed here.

Small-Cap Dividend Growth Offers Better Valuations than Small-Cap Value3

With valuations stretched, should one abandon small caps entirely? Small caps have a history of performing well during periods of rising rates and economic recovery4—a theme I will discuss in a future research piece—and I don’t think it is prudent to abandon small caps entirely because of more expensive valuations, but rather to search for pockets of potential value within small caps. This is an area I will focus on in this blog- small-cap dividend growers5. Valuations on this basket look attractive to me, at least as of March 31, 2014.

The U.S. SmallCap Dividend Growth Index (WTSDG) focuses on stocks from a broad small-cap dividend index6 that I believe have potential for dividend growth increases based on a proprietary combination of growth7 and quality8 metrics. What is interesting about valuations on WTSDG:

Higher Dividend Yield: WTSDG, which selects its constituents by high-growth and high-quality criteria, has a higher dividend yield9 than the Russell 2000 Value Index, which selects its companies largely on valuation characteristics (i.e. low price-to-book ratios).

Better Growth Potential: The Russell 2000 Value Index, due to its emphasis on valuation, has lower growth expectations than the Russell 2000 Index by about 2%. Traditionally, firms with inexpensive valuations tend to also have lower growth expectations. This trade-off is less pronounced in WTSDG, as it incorporates long-term earnings growth expectations into its methodology. In fact, WTSDG’s long term growth expectation stands at 14%, more than 2% higher than that of the Russell 2000 Value Index.

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