Small-caps are often to the first to take a hit in markets when concerns of recession rise to the surface, and while this year hasn’t been any different, the degree to which small-caps have been discounted remains disproportionate to their mid- and large-cap peers. This could provide continued opportunity for investors, particularly as the strong dollar drives investor focus towards domestic stocks, creating a potential tailwind for U.S. small-caps.
The Russell 1000 Index, which is comprised of U.S. large-caps, is currently sitting at a forward price-to-earnings ratio of 17.0x, slightly above its 20-year median of 16.5×. The Russell 2000 Index, which is comprised of U.S. small-caps, has a 20-year median of 17.2x, but its forward P/E is just 11.9×.
“It seems clear that fears of a near-term recession in the U.S. have had an outsized impact on the valuations of small caps relative to the broader market. While some of this repricing is likely warranted, given small caps’ historical volatility and sensitivity to economic growth, valuations relative to large caps are now less than two standard deviations below their long-term (20-year) average,” explained Andrew Okrongly, director, model portfolios at WisdomTree in a recent blog post.
The strong dollar is beginning to have outsized impacts on companies that do business overseas, predominantly large-cap companies within the technology, materials, and consumer staples sectors, while companies from real estate, utilities, and financials remain more concentrated domestically.
Image source: WisdomTree blog
“For investors seeking a level of protection from a stronger greenback and uncertainties abroad, U.S. small caps may help shield portfolios from these risks at attractive current valuations,” Okrongly wrote.
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Small-Cap Investing Two Ways
The WisdomTree U.S. SmallCap Fund (EES ) offers broad exposure to U.S. equity small-cap companies and seeks to track the WisdomTree U.S. SmallCap Index. The index is fundamentally weighted based on aggregate earnings of small-cap companies, and companies must have a P/E ratio of at least two for inclusion.
Companies included in the index must have the four most recent consecutive fiscal quarters exhibit positive cumulative earnings, and sector representation is capped at 25% (real estate is capped at 15%). The fund invests 95% of its assets in the index or similar securities under normal conditions and has an expense ratio of 0.38%.
The WisdomTree U.S. SmallCap Dividend Fund (DES ) seeks to track the WisdomTree U.S. SmallCap Dividend Index, an index comprised of the bottom 25% of dividend-paying companies by market cap that make up the WisdomTree U.S. Dividend Index after the 300 largest companies have been removed. The index is fundamentally weighted based on dividend projections for the next year, and DES carries an expense ratio of 0.38%.
Image source: WisdomTree blog
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