SInvesting in small caps may seem like one of the most upsetting ideas in the face of a recession, but as the space has already factored in recession risk, there are currently undeniable valuation opportunities within small caps. caps, if you don’t mind. overcoming volatility.
“The prospect of a Fed-induced recession to fight historic inflation has priced in valuation discounts so deep they are hard to ignore. If history is any indication, the future of small caps could be brighter than the bleak near-term forecasts suggest,” wrote Brian Manby, Principal Analyst, Research at WisdomTree, in a recent blog post.
Small cap markets are known to be riskier in general due to the higher number of companies that are unprofitable, especially during tough economic times. Manby explained that even when these unprofitable companies are removed from the Russell 2000 Index, the price-to-earnings and forward price-to-earnings ratios are deeply discounted to historically low levels.
Image source: WisdomTree blog
The Russell 2000 P/E and the futures P/E ratio are trading well below their long-term averages; volatility in May sent P/E two full standard deviations below the mean, and they are currently at a 30% discount with a range between 12x and 13x.
Markets have already priced in recession risks for small caps that are much heavier than their large and mid cap counterparts, largely due to the disproportionate effect on small company margins and earnings in a recessionary environment. While small caps have historically operated with a 5% P/E premium over large caps, this relationship has slowly eroded in recent years.
The forward P/E ratio of the Russell 2000 to the Russell 1000 (a representative of large caps) is below the long-term average, and the same is true for mid caps.
“For those who believe a recession is imminent, it is understandably counterintuitive to pay tribute to an asset class notoriously sensitive to economic growth amid rising interest rates and expectations of cuts. profits and profit margins,” Manby said. “But for the intrepid small-cap investor, the future has always looked bright after similar times.”
Over the past 20 years, small caps have fallen below a 20% discount to their long-term average forward P/E only nine times. Eight times, small-caps rallied and outperformed their large-cap counterparts by around 5% over a two-year period. A number of these cases occurred after major economic downturns, such as the onset of the COVID-19 pandemic and the financial crisis, and saw small caps benefit from a tailwind.
Image source: WisdomTree blog
The small cap game with WisdomTree
A popular choice this year for advisors and investors has been dividends, and the WisdomTree US SmallCap Quality Dividend Growth Fund (DGRS) offers smart play in the small cap space. DGRS invests in small cap US companies that pay dividends and exhibit growth characteristics, and applies a quality and growth screen to the securities. The fund seeks to track the WisdomTree US SmallCap Quality Dividend Growth Index, a fundamentally weighted index based on dividend projections for the next year that selects US small cap companies for long-term earnings growth expectations, return on equity and return on assets.
Another dividend game is the WisdomTree US Small Cap Dividend Fund (DES), which invests in small capitalization companies paying dividends on the American stock markets. The fund seeks to track the WisdomTree US SmallCap Dividend Index, an index comprised of the bottom 25% of dividend-paying companies by market capitalization that make up the WisdomTree US Dividend Index after the top 300 companies were removed. The index is fundamentally weighted according to dividend projections for the next year.
The WisdomTree US SmallCap Fund (EES) offers broad exposure to US small cap companies and seeks to track the WisdomTree US SmallCap Index. The index is fundamentally weighted to the aggregate earnings of small cap companies, and companies must have a P/E ratio of at least 2 to be included. The fund invests 95% of its assets in the index or similar securities under normal conditions.
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The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.