The Case For Small Cap Earnings (Sponsored)

Published on by on January 31, 2014 | Updated April 28, 2014

Small Companies, Big Potential. WisdomTree Helps You Capture It. Small-cap companies have historically been drivers of the U.S. economy and have often led the way out of recessions. They typically have more room to grow, and their size enables them to adapt to changing conditions—creating new products, workflows and efficiencies—more nimbly than their larger counterparts. Perhaps this is why they have tended to outperform large-cap companies over long periods.

In fact, with smart management, strong revenues and a lot of patience, many of the small companies of today have the potential to become the global leaders of tomorrow. At WisdomTree, we believe small companies deserve a place in most investors’ long-term portfolio. Additionally, in our opinion, a rules-based approach that focuses on earnings may enable investors to better capitalize on the small-cap segment of the market than a typical market capitalization-weighted approach would.

Furthermore, we believe investing in exchange-traded funds (ETFs) that are designed to track our fundamentally weighted Indexes is also an alternative to active management.

Consider that:

  • Small-cap stocks have tended to outperform their large-cap counterparts over long periods.
  • There is a value premium whereby value stocks have outperformed growth 6 stocks, and this has tended to be especially apparent in the comparison of small-cap growth and small-cap value equities.
  • Weighting by earnings may help capture this small-cap value premium by tilting weight to companies that generate greater amounts of earnings rather than those with larger market capitalizations.
  • A rules-based approach may provide a compelling alternative to active management.

Of course, approaches that emphasize investments in smaller companies generally experience greater price volatility than approaches that may encompass a more “broad market” focus capturing all size segments.

Small-Cap Stocks and the Value Premium

Eugene Fama and Kenneth French put forth the concept that stock returns are often a function of a stock’s exposure to various “risk premiums”. In theory, these risk premiums provide additional returns for value over growth and for small caps over large caps. Market returns bear this theory out. Consider that over the period from 12/31/1957 to 12/31/2012, the data compiled by Fama & French shows small-cap value equities outperformed large-cap value equities by 380 basis points per year. That may not sound like much, but on a hypothetical initial investment of $1,000 made on 12/31/1957, it translates to a difference of over $4 million.

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To further demonstrate the existence of a small-cap value premium, Fama & French compare small-cap value equities to small-cap growth equities over the same period. From 12/31/1957 to 12/31/2012, small-cap value equities outperformed small-cap growth equities by more than 800 basis points per year. If we assume a hypothetical investment of $1,000, this translates to a difference of more than $5.0 million. Now, there can never be any sort of guarantee that this trend will continue, but we feel that it indicates that there could potentially be a benefit to a process that focuses on maintaining a value bias.

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Capturing the Small-Cap Value Premium

The logical next step following the discovery of the small-cap value premium is to determine strategies that may give one a higher probability of capturing it. Traditionally, the small-cap equity universe in the United States is defined by the Russell 2000 Index. This index comprises companies defined as those ranking in order of market capitalization from 1,001 to 3,000 in Russell’s total United States equity universe of up to 4,000 companies. Major inclusion requirements consist of listing on a major U.S. exchange as well as a minimum closing price ($1.00) and market cap level ($30 million). In this market cap-weighted index, the largest companies by market cap receive the largest weighting, and they subsequently have the largest potential to impact performance. Weighting is not impacted by any fundamental measures, and companies in this index can have positive or negative earnings. We analyze returns of the Russell 2000 Index because it is one of the most common measures of the small-cap equity market in the United States.

At WisdomTree, we believe fundamentals such as dividends or earnings offer more objective measures of a company’s health, value and profitability than stock price alone. While the majority of indexes, such as the Russell 2000 Index, are market cap weighted—meaning they tend to give more weight to companies that sell at higher prices than those that offer stronger fundamentals—we have developed a proprietary Index methodology designed to help magnify the effect earnings have on total returns

For the WisdomTree SmallCap Earnings Index, we:

  • Focus on earnings rather than price.
  • Include only profitable companies (as of the annual Index screening date).
  • Weight companies by earnings stream.
  • Employ a disciplined annual rebalance to remove any companies that have become unprofitable and refocus exposure on small-cap stocks

A Focus on Earnings

We believe market cap weighting can lead investors to pay too much—especially in the small-cap space. Consider that the prices of small companies are typically less efficient than those of large companies. Since they are generally not as widely followed or as well known, market sentiment and other factors beyond actual business operations may impact the prices of small cap equities much more significantly than they do their large-cap counterparts. At WisdomTree, we seek to help solve this challenge by focusing on a measure of fundamental value, in this case, earnings. We believe this may provide a truer sense of what these companies are worth, especially during periods when markets can be driven to a greater degree by sentiment and emotion rather than by fundamental business operations at the actual firms.

Additionally, from our perspective, focusing on earnings goes beyond simply providing a better sense of a company’s worth to also giving investors a greater probability of capturing the so-called value premium. Essentially, for two firms with the same numbers of shares outstanding and the same earnings per share, the difference between weighting by earnings and weighting by market capitalization in this hypothetical example would be as follows:

  • The market capitalization-weighted approach would tilt weight toward the firm with the greatest market cap—and since each firm has the same number of shares outstanding, this means tilting weight toward the firm with the higher share price. Additionally, since each firm has the same level of earnings per share, this also means tilting the weight toward the firm with the higher price-to- earnings (P/E) ratio.
  • Since both firms have the same earnings per share, each would garner an equal weight within an earnings-weighted approach. Relative to market capitalization weighting, weight is removed from the firm with the higher market cap and pushed toward the firm with the lower market cap (and this is also the firm with the lower P/E ratio) .

Why might this be beneficial? Consider the research conducted by Professor Jeremy Siegel to determine the historical relationship between P/E ratio levels and equity returns. Professor Siegel discovered that not only did the stocks in the lowest P/E ratio quintile provide higher average annual returns and lower average annual standard deviation 20 than the S&P 500 Index over the period, but they also outperformed the stocks with the highest P/E ratios and did so with lower standard deviation, or risk—both compared to the broad S&P 500 Index and its highest P/E quintile. While the exact numbers would, of course, change for other universes of equities, we believe the overall conclusion—that there has been a historical difference in performance between higher- and lower-P/E stocks—extends beyond the S&P 500 Index and is applicable to the small-cap segment as well.

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Screening For Profitability

As mentioned previously, the Russell 2000 Index includes companies with positive and negative earnings. While this might offer an indication of the performance of U.S. small-cap stocks in general (as we know, they don’t all generate positive earnings), we believed that we could improve upon that methodology for those seeking something beyond broad performance measurement. Therefore, to be eligible for inclusion in the WisdomTree SmallCap Earnings Index, companies must be profitable, demonstrating four quarters of cumulative positive core earnings as of the annual screening date of the Index. At WisdomTree, this test is applied on an annual basis—not just for constituents to gain initial inclusion.

Additionally, rather than focusing on including a set number of companies, WisdomTree selects the bottom 25% of eligible market capitalization after removing the largest 500 from the selection universe. To ensure that we maintain our focus on small companies, we rebalance annually with a disciplined process aimed at capturing a set proportion of the eligible market capitalization—not looking to include any set numbers of firms or conform to pre-determined definitions of appropriate market capitalization boundaries. As a result, the weighted average market capitalization has dropped at each year’s Index rebalancing. We believe that the 2009 rebalance, occurring from 12/18/2009 to 12/21/2009, is of special interest in that it followed a large market rally, leading the methodology to decrease the weighted average market capitalization of the WisdomTree SmallCap Earnings Index by approximately 40% to refocus on small-cap stocks.

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Weighting By Earnings

According to Professor Siegel’s research, stocks with lower P/E ratios have tended to outperform those with higher ones. Subsequently, the WisdomTree SmallCap Earnings Index seeks to provide broad small-cap coverage with a distinct sensitivity to valuation. To help achieve this, we weight companies in the Index by their earnings stream rather than by market cap. Indexes such as the Russell 2000 Index, which weight by market cap, may in certain instances magnify the weight of more richly valued stocks or sectors, potentially raising the P/E ratio of the overall Index.

Using WisdomTree’s approach on the hypothetical portfolio of three stocks shown below, the portfolio P/E ratio was reduced from 11.5x (market cap-weighted result) to 8.16x (earnings-weighted result)—a reduction of almost 30%.

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Ultimately, the rebalancing process refreshes constituent weights based on the concept of relative value. Weights change at the rebalance based on each stock’s relative price appreciation compared to its relative earnings growth .

  • Companies whose stock prices increased relative to their peers’ while their earnings decreased relative to their peers’ would typically see reduced weight in the WisdomTree SmallCap Earnings Index. In a market cap-weighted index, the only driver of weight is the relative change in market capitalization, which is usually driven by the stock price.
  • Companies whose stock prices fell while their earnings were flat or grew would typically see increased weight in the WisdomTree SmallCap Earnings Index. In a market cap index, the only driver of weight is the lower market value, typically driven by lower stock prices .
  • Companies that have not been profitable over the previous four quarters are removed to ensure the continued focus on earnings-generating small-cap stocks.

Results That Speak For Themselves

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Outperformance Against Active Managers

A common misconception many investors hold is that, especially in small caps, active management is critical to successful investing. In addition to outperforming the Russell 2000 and Russell 2000 Value Indexes over the three- year, five-year and since-inception periods, the WisdomTree SmallCap Earnings Index has also outperformed over 83% of active managers over three years, 96% over five years and almost 91% since inception. In this figure, the WisdomTree SmallCap Earnings Index is up against the active managers and exchange-traded funds that Morningstar classifies within the Small Blend peer group.

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High Correlation to Russell 2000 Index

After performance is considered, a common follow-up question regards exposure. As the WisdomTree SmallCap Earnings Index utilizes both an earnings-weighted methodology and a profitability screen, investors may wonder if these practices cause a different exposure than the commonly viewed and cited market cap- weighted index benchmarks. Correlation is one way to consider exposure. The WisdomTree SmallCap Earnings Index has a correlation of 0.96 with the Russell 2000 Index and 0.97 with the Russell 2000 Value Index.

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Conclusion

In our opinion, small companies deserve a spot in every long-term portfolio. They may provide investors many attractive benefits not found in other markets. Small companies:

  • Are traditionally important components of the U.S. economy.
  • Typically have more room to grow and expand their earnings than large-cap companies .
  • Can more quickly respond to—and potentially capitalize on— shifting trends than large companies.
  • Have historically outperformed their large-cap counterparts over long periods.
  • Have traditionally provided a significant performance premium for value vs. growth exposure.

At WisdomTree, we do things differently. We build our Indexes and the ETFs designed to track them with proprietary methodologies, smart structures and/or uncommon access to provide investors with the potential for income, performance, diversification and more. In the small-cap market, we believe our approach can help investors more successfully capture the value premium in small companies.

We built our SmallCap Earnings Index with a rules-based process that focuses on earnings and profitability, weights by earnings and rebalances on an annual basis. As of 9/30/2013, the WisdomTree SmallCap Earnings Index:

  • Outperformed the Russell 2000 Index over the one-year, three-year, five-year and since-inception periods.
  • Exhibited a lower P/E ratio than the Russell 2000 Index.
  • Outperformed almost 91% of active managers & ETFs since inception, defined by those within the Morningstar Small Blend peer group.