For over a decade, small-caps were laggards. They were relegated to “has been” bin alongside value and international equities. All the while, domestic large-cap growth stocks thrived.
It will take a while for small-caps and related exchange traded funds to make up for lost time. But the asset class has recently shown signs of life. For the 90 days ending July 29, the Russell 2000 and the S&P SmallCap 600 indexes returned an average of 11.5%, besting the large-cap S&P 500 by 400 basis points during that span. The WisdomTree U.S. SmallCap Dividend Fund (DES) joined the party, surging more than 11% over that period.
DES follows the WisdomTree U.S. SmallCap Dividend Index. Its no stranger to solid outperformance on a relative basis. Over the past three years, the ETF is up 20.4% and the Russell 2000 is up just 4.9% during that time frame. DES also beat the S&P SmallCap 600 by 830 basis points over that period. And the fund was noticeably less volatile on an annualized basis than the two small-cap benchmarks over those three years.
DES Methodology Matters
As its name implies, DES focuses on small-cap dividend payers. Alone, that trait can stem some of the volatility associated with smaller equities. However, dividends imply some level of fundamental sturdiness. That’s a coveted trait when it comes to small-caps and one that fortifies the case for DES.
“Poor small cap fundamentals (particularly portfolios that look like the Russell 2000) may prevent small cap from mounting its seventh sustained period of outperformance, but for diversified investors thinking about small cap stocks, today’s valuations offer the cheapest entry point in the 21st century,” observed Michael Cembalest of J.P. Morgan Asset & Wealth Management.
Another potential catalyst for small-caps and ETFs such as DES is the presidential election. While there’s much to be decided between now and Election Day, Cembalest noted a particular outcome could be a boon for smaller stocks.
“(Former President Donald) Trump has mentioned the possibility of higher tariffs on China and the rest of the world (which typically hurts large cap stocks the most), while Vance has said positive things about Lina Khan’s FTC (despite her department losing almost all antitrust cases it brings),” he added. “If a second Trump administration raises tariffs and ratchets up antitrust enforcement of large cap tech stocks, that could be a small cap relative value catalyst, albeit at a time of possibly declining overall US equity markets.”
DES’ Light Could Shine Bright
Getting back to small-cap fundamentals, DES could shine bright if market participants revisit small-caps in earnest while looking for traits that could potentially result in lower risk.
“Relative to US large cap, US small cap stocks have (a) lower free cash flow margins, (b) a lot more companies with negative earnings, (c) lower return on invested capital, (d) more floating rate debt, (e) higher debt to cash flow ratios, (f) higher interest expense to cash flow and (g) ~70% of debt falling due in the next 5 years compared to 45% for large cap,” concluded Cembalest.
Those negatives aren’t applicable to many DES holdings.
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