Keeping With Quality Could Be A Rewarding Small-Cap Approach In 2020

Small-cap stocks badly lagged their large-cap rivals last year. The Russell 2000 and S&P SmallCap 600 indexes returned an average of just 24% compared to 31.2% for the large-cap S&P 500, including dividends paid.

A traditional result of small caps being a laggard in a particular year is that the market observers often opine that smaller stocks are primed to outperform larger rivals in the following year and that's the case again in 2020.

Investors that want small-cap exposure but are leery about just how much upside the segment can offer this year should approach the group in conservative fashion and can do so with the WisdomTree U.S. SmallCap Quality Dividend Growth Fund DGRS.

Why It's Important

DGRS yields 2.4%, well above the dividend yields found on either of the aforementioned small-cap benchmarks. However, DGRW, which tracks the WisdomTree U.S. SmallCap Quality Dividend Growth Index (WTSDG), is a dividend growth, not a yield, strategy and that's to investors' benefit.

The WisdomTree product emphasizes profitability, an important component when it comes to payout growth and sustainability and one that many small-cap ETFs don't focus on. As a result, DGRS's combined weight of less than 8% to technology and healthcare is well below average for a small-cap fund, but in the small-cap universe, those sectors are often home to unprofitable companies.

“From a sector perspective, the Index is overweight cyclicals like Materials and Industrials, and underweight sectors with low profitability and low dividend payments like Health Care and Information Technology,” WisdomTree said in a recent note. “Despite its screen on long-term earnings growth expectations, the Index’s methodology favors companies with current profitability over the lottery-ticket type companies with low or no profits that tend not to pay dividends (about half of Russell 2000 constituents do not pay dividends).”

What's Next

DGRS's reduced weight to growth fare from the health care and technology sectors not only moves the yield needle, but it gives the fund a value feel relative to broader small-cap benchmarks.

“The overweight to cyclical sectors results in lower valuations on price-to-earnings and price-to-sales, and dividend weighting produced a yield advantage of over 140 bps, as of the December rebalance,” according to WisdomTree.

DGRS came into 2020 with a forward price-to-earnings ratio of about 14x compared to almost 17 times for the Russell 2000.

Related Links:

Four Google-Heavy ETFs

Three China ETFs to Buy Now