Beware Small-Cap Value Traps | ETF Trends

There are times when value investing is in style, but it’s always a good idea to avoid value traps. That sentiment is particularly applicable today with small-cap stocks and the related exchange traded funds.

The valuation gap between large- and small-cap equities is, by some accounts, as wide as it’s been in multiple decades. That doesn’t mean that all small-cap stocks are good deals, but it could signal that selectivity will be rewarded. The WisdomTree US Smallcap Quality Dividend Growth Fund (DGRS) answers that bell.

As its name implies, DGRS focuses on quality. This trait is of particular importance with small-caps because many members of traditional small-cap benchmarks aren’t profitable companies. There are times when markets reward shares of money-losing, but the current environment isn’t one of those times.

DGRS Benefits Playing Out in Real Time

Alone, the dividend dictate found with DGRS is appealing. The small-cap space, though improving, isn’t viewed as a bastion of dividends. Additionally, across all market capitalization segments, dividend payers are often less volatile than their non-payout counterparts.

That’s been on display this year as DGRS is sporting slightly less annualized volatility than the S&P SmallCap 600 Index while outperforming that benchmark as well as the Russell 2000 Index. That’s old hat for DGRS. Over the past three years, DGRS has been less volatile than that pair of small-cap gauges. Still, it has easily outperformed both.

Part of DGRS’s success is that many dividend payers often have stronger balance sheets than non-dividend payers. That includes less indebtedness – a vital factor for investors to consider at a time when interest rates are high.

“The average interest rate paid on company debt climbed since the start of the year to just under 6% for both the S&P 600 and Russell 2000. These rates are now back to pre-pandemic levels, and we expect they will continue to increase through the end of this year,” noted WisdomTree’s Brian Manby.

Call the average interest rate incurred by small-cap borrowers 6%. That’s nearly 130 basis points where 10-year Treasury yields currently reside. Alone, that’s potentially ominous. It’s even more so when considering higher interest rates mean more of a company’s pre-tax earnings are allocated to covering interest expenses. In that scenario, shareholder rewards are likely to not be a priority for such firms underscoring the viability of the DGRS methodology in the current market environment.

“Higher interest expenses are also starting to consume greater portions of trailing earnings before interest and taxes (EBIT) and revenues within the S&P 600 and Russell 2000. Larger companies who tap the bond markets for their loans are able to extend maturities like the typical mortgage refinancer and have been better fortified against these rising cost,” concluded Manby.

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