Chris Gannatti of WisdomTree Europe reviews the attractions of investing in smaller companies in the US, Japan, Europe and the emerging markets.
Small companies are quite easy to ignore. After all, analysts rarely cover them, you may not have heard of them, and you are unlikely to have their products in your home. However, small companies are often the ones that offer the biggest potential.
Consider that small companies are innovative. They are creating the products, services and technologies we may not know today but will come to rely on tomorrow. Certainly, they come with more risk, but they also come with more reward potential. In fact, over the long term, small-cap stocks have outperformed both their large-cap brethren and the market in general, as you can see from Figure 1.
Additionally, it is worth noting that, in addition to their growth potential, small companies in Europe often pay dividends. Dividends provide both a potentially growing stream of income and a measure of protection in down markets.
We believe that small companies can provide growth opportunities for investors. Further, we believe that small-cap dividend-payers may help to mitigate the volatility of small-cap investments. It is worth noting that, as small companies are not as widely followed as their larger counterparts, there is more opportunity for a stock’s price to be out of alignment with the company’s true value.
At WisdomTree, we weight indices by dividend in order to magnify the effect dividends have on performance. We use a rules-based process and rebalance back to relative value at least annually. In our opinion, less efficient markets such as the small-cap arena are precisely where our rules-based process can work best.
Small companies – and especially small companies that pay dividends – may offer investors some rather large opportunities. And these opportunities can also be quite global. Small-cap dividend-payers exist in emerging markets, in Japan, in the US, as well as in Europe and everywhere around the world. Further, they often pay larger dividends than you might expect.
In Figure 2, we indicate WisdomTree’s approach to small caps, which only includes dividend-paying small-cap stocks and weights them by their cash dividends. ‑ is approach has led to the potential for higher dividend yields in markets around the world. While dividends themselves are something that investors can touch and feel at a regular frequency (so long as they are paid), Figure 2 represents the relationship between the current share prices of the underlying index constituents and the dividends that those constituents have paid over the prior 12 months.
Within each respective colour, we are illustrating the difference that WisdomTree’s dividend-weighted approach has made relative to a relevant, well-known, market capitalisation-weighted benchmark. While the magnitude of the dividend yield difference may change over time, the fact of the dividend-weighted approach having a higher dividend yield than the market capitalisation-weighted approach has been consistent throughout the life history of these specified indices.
At each annual rebalance, stocks whose share prices have risen quickly but whose dividend growth has not kept pace will tend to see their weights reduced within WisdomTree’s methodology.
With market capitalisation-weighted approaches, stocks with greater market capitalisation receive greater weights, regardless of valuation. In contrast, stocks whose share prices have remained at or fallen, but whose dividend growth has been relatively strong will tend to see their weights increased within WisdomTree’s methodology. With market capitalisation-weighted approaches, stocks with smaller market capitalisation receive lower weights.
As the world has become more interconnected, large-cap companies tend to be multinational and do business globally. Small caps, on the other hand, tend to be much more exposed to their local economies. If one is thinking of diversification on the basis of economic conditions and growth potential in different segments of the world, small caps may provide an interesting tool to use for this type of execution.
History has shown that small caps have delivered strong performance over their large-cap counterparts in regional markets worldwide over the long term. We have listed four areas where we believe small caps are of particular interest.
In a world dominated by trade rhetoric, small-cap companies in the US do the majority of their business within US borders and are less exposed to trade. Additionally, prior to the corporate tax cuts of December 2017, they were paying higher effective tax rates than their large-cap peers, and therefore benefited more from this policy change.
Japanese small caps receive approximately 80% of their revenues from inside Japan. As the economic policies of prime minister Shinzō Abe focus on domestic Japan, small caps may be a better way to benefit than larger, export-oriented firms.
European small caps tend to be very well geared to shifts in sentiment, and they also do most of their business domestically. At times when it has been beneficial to avoid Europe’s largest banks, small caps have had this natural side effect.
Many investors we speak to focus on billions of consumers within emerging markets raising their standards of living and driving global growth. Small-cap companies can tap into this demographic theme better.
In many cases, we have seen the most enthusiasm from investors who have not considered small-cap equities before, particularly in markets outside their home region. Tapping into local revenue streams could be a critical element to bring the potential for differentiated performance.
Chris Gannatti is head of research at WisdomTree Europe.