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Domestic Small-Caps Getting Too Interesting to Ignore

With the Russell 2000 Index up just 1% year to date, small-caps stocks and related ETFs aren’t giving investors much to cheer about. But recent weakness among smaller equities has created valuation opportunities that may be too compelling to ignore.

That could bode well for ETFs such as the WisdomTree U.S. SmallCap Dividend Fund (DES). The $1.76 billion DES, which follows the WisdomTree U.S. SmallCap Dividend Index, could be interesting to investors at a time when small-cap stocks appear unusually cheap.

Another point in the WisdomTree ETF’s favor is its dedication to dividends. That’s something many investors don’t think of when evaluating small-cap stocks. DES’ dividend DNA has paid off for long-term investors. Over the past three years, the fund has soundly outperformed the Russell 2000 and S&P SmallCap 600 indexes. It’s also delivering less annualized volatility than those gauges.

Small-Caps ETF DES’ Value Proposition

DES isn’t a value ETF in the strictest sense of the term. But regardless of market capitalization spectrum, there  are often links between value and dividend-paying equities. That’s relevant because current valuations on small-caps could be a harbinger of upside to come.

“Since the end of July, the Russell 2000’s price-to-book has fallen by 16% to 1.8, which is close to the biggest discount to large caps on record. When small caps have traded at this type of discount in the past, they have historically gone on to deliver strong returns over the following 12 months and tended to outperform large caps,” noted Geoff Dailey, BNP Paribas head of U.S. equities.

Another reason to consider DES is that many dividend-paying companies are profitable or, at the very least, have avenues for supporting their payouts. Profitability isn’t guaranteed some traditional small-cap structures.

“If you compare the price-earnings ratios of profitable small caps (around a third of Russell 2000 companies are life science or tech companies that lose money) to large caps, they are trading at about a 30% discount — the widest gap since the peak of the tech bubble in 2000,” added Dailey.

That could be a sign there’s value in DES’s relatively small lineup. The WisdomTree ETF is home to 613 stocks, not necessarily “small,” but smaller than the Russell 2000 roster. That quality tilt could be rewarding as small-caps attempt to play catch-up with large-caps.

“We are still at extreme levels of valuation with the price-earnings ratio of small caps relative to large caps close to the lows of the past 20 years. We expect that gap to narrow,” concluded Dailey.

For more news, information, and analysis, visit the Modern Alpha Channel.

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