Don’t Pay Large For Small Caps

Black Friday is long behind us, but the importance of finding bang-for-your-buck is a year-round endeavor. While it’s human nature to want to pay as little as possible for the best products, that’s often easier said than done, and the best deals can be elusive.

When investing, valuation ratios can serve as your “bargain hunter,” as they indicate how much you’re paying to access the fundamental health of the underlying investment. At WisdomTree, we pay special attention to valuations, since many of our strategies are implicitly designed to keep them in check.

How Can Earnings Help?

WisdomTree’s core family of funds manages valuations by weighting their underlying companies by earnings per share. Those with greater earnings over the previous 12 months receive greater weight than those with less, rewarding businesses with impressive financial health and efficient operations.

An important byproduct of this method is that the Funds’ valuations remain subdued, especially after rebalancing each December.

The benefit has been especially apparent in U.S. small caps, which is traditionally one of the more speculative asset classes due to investors’ desire for small companies with exciting business prospects. As a result, small caps typically have expensive price-to-earnings (P/E) valuations.

Look no further than the Russell 2000 Index for proof. As of 2019, its 10-year median P/E ratio is 35, and it’s currently trading even higher at 46. By comparison, the earnings-weighted WisdomTree U.S. SmallCap Fund (EES) has a median P/E of only 14, and it’s currently trading at a 15% discount to its median after rebalancing in December.

Figure 1: U.S. Small Cap Valuation Performance Comparison

Figure 1_U.S. Small Cap Valuation Performance Comparison

For standardized performance of EES, please click here.

But if both EES and the Russell 2000 Index provide exposure to the same market, what’s causing the valuation gap?

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