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.”1
• 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.2
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 volatilty?
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.
o 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.3