The Forgotten Dividend Payers: Mid- and Small-Cap Equities

Transcription

1 Research MARKET INSIGHTS [ March 2014 ] The Forgotten Payers: Mid- and Small-Cap Equities BY JEREMY SCHWARTZ, CFA, DIRECTOR OF RESEARCH & TRIPP ZIMMERMAN, CFA, RESEARCH ANALYST Last year, longer-term interest rates in the U.S. rose considerably mostly driven by the expectation that the Federal Reserve (Fed) would begin tapering 1 its quantitative easing (QE) 2 program. At its December meeting, the Fed began scaling back purchases of both mortgage-backed securities and U.S. Treasury bonds by $10 billion a month and now is on track to end its asset purchase program by the end of 2014 assuming no drop-off in economic performance in the coming months. The rise in Treasury yields since the beginning of 2013 impacted various income-oriented investment strategies, but not all strategies are the same. When investors think of dividends, they tend to think of mature large-cap 3 companies as the primary source, and as a result, we feel that many investors mistakenly overlook potentially attractive income options. Below we will discuss one segment of the market that often gets overlooked in the hunt for income-producing asset classes mid- and small-cap dividend payers. IN SEARCH OF INCOME: LOOK TO MID- AND SMALL CAPS We feel many investors mistakenly assume that mid- and small-cap companies are solely focused on growth and therefore reinvest their earnings instead of paying them out in the form of dividends. If you take a look at traditional market cap-weighted indexes for the United States in particular, this assumption seems to be accurate: + Going down the size spectrum from the Russell 1000 (large cap) to the Russell Midcap (mid-cap) and the Russell 2000 (small cap) in the Russell index family of market cap-weighted 4 indexes illustrated in figure 1, the indexes that focus on larger market capitalization companies have higher trailing 12-month dividend yields. 1 Tapering: A shift in monetary policy by which the Federal Reserve would begin decreasing the amount of bonds it purchases. 2 Quantitative easing (QE): A central bank monetary policy occasionally used to increase the money supply by buying government securities or other securities from the market. Quantitative easing increases the money supply by flooding financial institutions with capital in an effort to promote increased lending and liquidity. 3 Size capitalization: A measure by which a company s size is classified. Large caps are usually classified as companies that have a market cap over $10 billion. Midcaps range from $2 billion to $10 billion. Small caps are typically new or relatively young companies and have a market cap between $200 million and $2 billion. 4 Market capitalization weighting: Market cap = share price x number of shares outstanding. Firms with the highest values receive the highest weights in approaches designed to weight firms by market cap.

2 Research MARKET INSIGHTS [ March 2014 ] However, this does not necessarily have to be the case; there are many profitable mid- and small-cap companies that can afford to, and do, pay dividends. Market capitalization-weighted indexes provide the benefit of as broad an exposure as possible to a given universe of stocks, but they do not directly focus on dividends or dividend payers. When applies its domestic dividend methodology, it includes only dividend-paying companies and then weights these constituents based on their Streams 5. While potentially not as broadly focused as market capitalization-weighted indexes, when combined, these elements tend to produce very different trailing 12-month dividend yields 6 for s LargeCap, and es. FIGURE 1: DIVIDEND YIELD AND SIZE SEGMENT OF THE MARKETS 3.50% 3.00% 3.23% 3.13% 2.50% 2.73% Yield (%) 2.00% 1.50% 1.89% 1.85% 1.55% 1.00% 1.29% 0.50% 0% S&P 500 Russell 1000 Russell Midcap Russell 2000 LargeCap Sources:, Bloomberg (12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. + Small & Mid-Caps for Income: In the current environment, s domestic es turn this way of thinking on its head the (WTSDI) and the (WTMDI) had a yield advantage over the LargeCap, the S&P 500 and the Russell INTERNATIONAL MID- AND SMALL-CAP DIVIDENDS While we focused on mid- and small-cap dividend payers in the United States above, we now extend the analysis to developed international markets. We believe the benefits of looking beyond large caps and into mid- and small caps are, in many ways, even stronger in the international markets. 5 Stream: dividend per share multiplied by the number of shares outstanding for each index constituent. 6 Trailing 12-month dividend yield: s over the prior 12 months are added together and divided by the current share price. Higher values indicate more dividends are being generated per unit of share price. 2

3 Research MARKET INSIGHTS [ March 2014 ] For starters, international markets generally pay more dividends than U.S. markets which means they represent a bigger investment opportunity set. The Stream for the Global was over $1 trillion, 7 and while the U.S. market made up 31.1% of the total Stream, the developed world ex-u.s. accounted for 52.1% of it. The international developed world also tends to have higher trailing 12-month dividend yields than the United States, which is illustrated in the chart below. FIGURE 2: DIVIDEND YIELD AND SIZE SEGMENT OF THE MARKETS 4.50% 4.00% 3.50% 3.83% 3.86% 3.73% Yield (%) 3.00% 2.50% 2.00% 1.50% 3.05% 2.90% 2.38% 1.89% 1.00% 0.50% 0% Mid Cap Small Cap S&P 500 LargeCap Sources:, Bloomberg (12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. + Equities Have Higher Yields: All the indexes and es shown above have higher trailing 12-month dividend yields than the S&P 500, a proxy for the U.S. markets. + es Have Highest Yields: weights companies in its es by cash dividends, which tends to increase the yield compared to traditional market cap-weighted benchmarks that do not weight by dividends. Each of these es has close to twice the trailing 12-month dividend yield of the S&P and es Also Pay: As you move down the size spectrum in the family, you do not see a substantial decrease in the trailing 12-month yield that is present in the indexes, where the largest-market-capitalization firms have the highest trailing 12-month dividend yields. 7 As of annual screening date May 31,

4 Research MARKET INSIGHTS [ March 2014 ] WHY INTERNATIONAL DIVIDENDS? Over the past few years, one case in support of dividend-paying stocks highlighted the yield advantage they offered over Treasuries. More recently, that yield advantage has closed and the percentage of equities with a higher dividend yield than the 10-Year U.S. Treasury yield 8 has declined. There is still a healthy part of the broader market that can offer higher yields than U.S. Treasuries, but it is no longer the majority of stocks in the market, so it would be hard to notice by looking only at large-cap indexes weighted by market cap. At we weight eligible companies in our es by their Stream, which enables us to magnify the effect of dividends. Figure 3, below, illustrates this point by separating the weight each index has in stocks that had a higher dividend yield than the 10-Year Treasury. FIGURE 3: PERCENTAGE OF INDEX WITH DIVIDEND YIELD AHEAD OF 10-YEAR U.S. TREASURY YIELD [ 3.03% on 12/31/13 ] 80% 70% 72% 60% Yield (%) 50% 40% 30% 54% 54% 47% 43% 39% 31% 20% 10% 16% 15% 13% 13% 0% LargeCap MSCI EAFE LargeCap S&P 500 Russell 1000 Russell Midcap Russell 1000 Sources:, Bloomberg (12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. + es Have More Weight in High Payers: The international dividend indexes displayed above tend to have higher weights in higher-yielding companies than the S&P 500, allowing them to have a higher percentage weight in stocks with a dividend yield over the U.S. 10-Year Treasury. We find it impressive that the (WTIMDI) and (WTISDI) have over three times the weight in stocks with a yield advantage over the U.S. Treasury than does the S&P 500, especially considering many U.S. investors think of domestic large caps first when they think about dividends. + Small & Mid-Caps for Domestic Focus: We find it impressive that WTSDI and WTMDI had more than twice the weight of the S&P 500 in stocks with a dividend yield higher than the 10-Year Treasury. It is even more impressive considering WTSDI and WTMDI had more than three times the weight of the Russell Midcap and Russell 2000 indexes, their market cap-weighted benchmarks. 8 Treasury yield: The return on investment, expressed as a percentage, on the debt obligations of the U.S. government. 4

5 Research MARKET INSIGHTS [ March 2014 ] POSSIBLE DIVERSIFICATION BENEFITS: MID- AND SMALL CAPS We feel that investors typically have a large-cap bias when it comes to income as well as in their general portfolio allocation decisions. We believe that mid- and small-cap dividend payers offer a further set of exposures beyond traditional large caps and can potentially lower portfolio risk 9 and enhance returns through these diversification benefits. Moreover, the stocks themselves tend to display different characteristics than large-cap stocks, as illustrated by their sector differentials (figure 4), specifically the exposure to cyclical 10 and defensive 11 sectors. FIGURE 4: SECTOR DIFFERENTIALS: CYCLICALS VS. DEFENSIVES Domestic 90% 85% Sector Exposure (%) 80% 70% 60% 50% 40% 30% 76% 24% 76% 75% 72% Cyclicals 68% Defensives 48% 52% 32% 28% 24% 25% 70% 30% 63% 37% 58% 42% 20% 15% 10% 0% S&P 500 NASDAQ US Achievers Select Dow Jones U.S. Select MSCI EAFE Dow Jones EPAC Select NASDAQ Achievers Sources: Bloomberg, (12/31/13). You cannot invest directly in an index. Subject to change. + Cyclical Sector Over-weights: The es displayed above tend to have more exposure to the cyclical sectors of the markets compared to popular large-cap market cap-weighted benchmarks such as the S&P 500 and the. The cyclical sector over-weight is even greater when compared against other dividend-focused indexes, such as the NASDAQ and the Dow Jones indexes. + Defensive Sector Under-weights: Unlike traditional dividend-paying stocks, the es shown above tend to be under-weight in a number of the traditional dividend-paying sectors. The defensive sector under-weight is even greater when compared against other dividend-focused indexes. 9 Risk: Also standard deviation, which measures the spread of actual returns around an average return over a specific period. Higher risk indicates greater potential for returns to be farther away from this average. 10 Cyclical sectors: Includes Consumer Discretionary, Energy, Industrials, Materials, Financials and Information Technology sectors. 11 Defensive sectors: Consumer Staples, Health Care, Telecommunication Services and Utilities. 5

6 Research MARKET INSIGHTS [ March 2014 ] If one believes that the U.S. or the global economy is starting to recover which is one of the key factors that can support a further increase in interest rates one might want to supplement traditional large-cap allocations with increased weight in the more cyclical mid- and small-cap segments such as those shown above whether in the United States or overseas. A CLOSER LOOK AT MID- AND SMALL CAPS Mid- and small-cap stocks have traditionally outperformed large-cap stocks over long periods. This outperformance is typically a result of the higher growth potential of mid- and small-cap companies, but it also is usually associated with greater risks due to the volatility in earnings and uncertainty about new or unproven business models. We feel this view incorrectly stereotypes all mid- and small-cap companies, and we do not think all mid- and small-cap companies are created equal. There are many mid- and small-cap companies that have proven business models with relatively stable earnings streams. We believe these companies have the ability to pay out dividends to shareholders and grow them over time and the es focus on these firms. FIGURE 5: PERFORMANCE SINCE WISDOMTREE INDEX INCEPTION 9.00% 8.00% 8.56% 8.47% 7.98% 7.98% 7.88% Annualized Performance (%) 7.00% 6.00% 5.00% 7.34% 6.69% 6.41% 5.29% 5.15% 4.93% 4.00% 3.00% 3.57% 3.57% 3.49% Russell Midcap Russell 2000 Russell Midcap Value S&P 500 Russell 2000 Value Small Cap Value Small Cap Mid Cap Mid Cap Value Sources:, Bloomberg (06/01/ /31/2013). Past performance is not indicative of future results. You cannot invest directly in an index. Inception for all indexes listed above was 06/01/ Domestic Mid- and Small Caps Led: Domestically focused indexes outperformed all internationally focused indexes above, and all but one of the domestic small and mid-cap indexes outperformed the S&P 500. Within the United States, midcap indexes beat small and large caps, and core segments beat value cuts. 6

7 Research MARKET INSIGHTS [ March 2014 ] + es Led: Among the developed international indexes, both the and the outperformed the other, more traditional large-cap and market cap-weighted international indexes listed above. Most international small-cap indexes led mid- and large caps, but there was no clear divergence between core and value among the market cap indexes. + Performance Divergence Largest among Markets: WTISDI and WTIMDI were able to outperform the MSCI EAFE by over 2.9% and 1.80% per year, respectively, since their inception. The outperformance of domestic small caps was much lower over the same period, with WTSDI and WTMDI outperforming the S&P 500 by over 1.1% and.5%, respectively. OUTPERFORMANCE AGAINST MANAGERS A common misconception many investors hold is that, especially in more inefficient markets such as mid- and small caps, active management 12 is critical to successful investing. We have looked at the data and do not accept this premise. strategies have performed quite well against their active manager peer groups, especially as periods are extended to five years and beyond. FIGURE 6: MID-CAP PERFORMANCE Average Annual Returns 1-Year 3-Year 5-Year Since WT Inception 33.25% 17.39% 21.36% 8.47% Russell Midcap 34.76% 15.88% 22.36% 8.56% Russell Midcap Value 33.46% 15.97% 21.16% 7.98% Percentage of Morningstar Mid-Cap Value Managers Beaten 1-Year 3-Year 5-Year Since WT Inception 32.9% 69.6% 69.7% 73.1% Russell Midcap 44.2% 44.3% 85.1% 73.5% Russell Midcap Value 33.3% 45.3% 66.0% 65.0% Number of Managers Sources:, Bloomberg, Zephyr StyleADVISOR (06/01/06 12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. Inception date for the was 06/01/ The was able to outperform the Russell Midcap Value, its performance benchmark, by approximately 0.50% on an average annual basis since inception. The also outperformed over 73% of active managers and ETFs in the Morningstar Mid-Cap Value peer group since inception, and over 69% over the most recent three- and five-year periods. 12 Active manager: Portfolio managers who run funds that attempt to outperform the market by selecting those securities they believe to be the best. 7

8 Research MARKET INSIGHTS [ March 2014 ] FIGURE 7: SMALL-CAP PERFORMANCE Average Annual Returns 1-Year 3-Year 5-Year Since WT Inception 36.16% 16.75% 19.83% 7.88% Russell % 15.67% 20.08% 7.98% Russell 2000 Value 34.52% 14.49% 17.64% 6.69% Percentage of Morningstar Small Value Managers Beaten 1-Year 3-Year 5-Year Since WT Inception 37.6% 70.9% 35.2% 54.8% Russell % 47.8% 38.5% 57.4% Russell 2000 Value 25.1% 26.7% 8.8% 27.0% Number of Managers Sources:, Bloomberg, Zephyr StyleADVISOR (06/01/06 12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. Inception date for the was 06/01/ The was able to outperform the Russell 2000 Value, its performance benchmark, by 1.19% on an average annual basis since inception. The also outperformed over 54% of active managers and ETFs in the Morningstar Small Value peer group since inception, and over 70% over the most recent three-year period. FIGURE 8: INTERNATIONAL PERFORMANCE Average Annual Returns 1-Year 3-Year 5-Year Since WT Inception 23.06% 8.08% 14.27% 5.29% Mid Cap 24.37% 8.06% 14.04% 3.57% Mid Cap Value 25.37% 8.22% 13.96% 3.57% 27.35% 10.89% 18.60% 6.41% Small Cap 29.30% 9.26% 18.50% 4.93% Small Cap Value 31.60% 9.54% 18.47% 5.15% Percentage of Morningstar Foreign Small & Mid-Cap Value Managers Beaten 1-Year 3-Year 5-Year Since WT Inception 34.47% 52.71% 14.32% 74.20% Mid Cap 52.39% 52.61% 13.21% 15.91% Mid Cap Value 61.13% 53.36% 12.86% 15.83% 68.47% 85.17% 57.39% 85.16% Small Cap 81.58% 66.57% 56.72% 65.24% Small Cap Value 90.92% 69.87% 56.52% 70.21% Number of Managers Sources:, Bloomberg, Zephyr StyleADVISOR (06/01/06 12/31/13). Past performance is not indicative of future results. You cannot invest directly in an index. Inception dates for the es above was 06/01/

9 Research MARKET INSIGHTS [ March 2014 ] + The was able to outperform the Mid Cap, its performance benchmark, by 1.72% on an average annual basis since inception. The also outperformed over 74% of managers in the Morningstar Foreign Small & Mid-Cap Value peer group. + The was able to outperform the Small Cap, its performance benchmark, by 1.48% on an average annual basis since inception. The also outperformed over 85% of managers in the Morningstar Foreign Small & Mid-Cap Value peer group. 9

10 Research MARKET INSIGHTS [ March 2014 ] CONCLUSION We believe one of the supporting points for equities during the last few years was the income advantage they provided compared to the traditionally low yields available in fixed income securities. There is still a healthy part of the broader market that can offer higher yields than U.S. Treasuries, but it is no longer the majority of stocks in the market, and investors shouldn t look to just large-cap equities. In our opinion, if investors want to focus on equities for their income potential, mid- and small-cap companies are important tools for providing diversification benefits and increased potential return. Specifically, we think that both domestic and international mid- and small-cap dividend-paying companies deserve a larger share than they re currently being allocated. Diversification does not eliminate the risk of experiencing investment losses. s are not guaranteed, and a company s future ability to pay dividends may be limited. A company paying dividends may cease paying dividends at any time. Investments focusing on certain sectors and/or smaller companies increase their vulnerability to any single economic or regulatory development. This may result in greater share price volatility. Foreign investing involves special risks, such as risk of loss from currency fluctuation or political or economic uncertainty. The Dow Jones U.S. Select is calculated, distributed and marketed by Dow Jones es, a licensed trademark of CME Group Services LLC, and has been licensed for use. Investors should carefully consider the investment objectives, risks, charges and expenses of the Funds before investing. To obtain a prospectus containing this and other important information, call WISE (9473) or visit wisdomtree.com. Read the prospectus carefully before you invest. LargeCap : A fundamentally weighted index that measures the performance of the large-capitalization segment of the U.S. dividendpaying market. The comprises the 300 largest companies ranked by market capitalization from the. : A fundamentally weighted index that measures the performance of the mid-capitalization segment of the U.S. dividend-paying market. The comprises the companies that constitute the top 75% of the market capitalization of the after the 300 largest companies have been removed. The is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. : A fundamentally weighted index that measures the performance of the small-capitalization segment of the U.S. dividend-paying market. The comprises the companies that constitute the bottom 25% of the market capitalization of the after the 300 largest companies have been removed. The is dividend weighted annually to reflect the proportionate share of the aggregate cash dividends each component company is projected to pay in the coming year, based on the most recently declared dividend per share. Russell 1000 : A measure of the performance of the 1,000 largest companies by market capitalization in the Russell Russell Midcap : Measures the performance of the mid-cap segment of the U.S. equity universe. The Russell Midcap is a subset of the Russell It includes approximately 800 of the smallest securities based on a combination of their market cap and current index membership. Russell Midcap Value : Measures the performance of the mid-cap value segment of the U.S. equity universe. It includes those Russell Midcap companies with lower price-tobook ratios and lower forecasted growth values. Russell 2000 : A market capitalization-weighted index that measures the performance of the 2,000 smallest securities in the Russell Russell 2000 Value : Measures the performance of the small-cap value segment of the U.S. equity universe. It includes those Russell 2000 companies with lower price-to-book ratios and lower forecasted growth values. Global : s broadest measure of dividend-paying stocks, including firms incorporated in emerging markets, developed international markets and the United States, weighted by cash dividends. LargeCap : A fundamentally weighted index that measures the performance of the large-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The comprises the 300 largest companies ranked by market capitalization from the DEFA. Companies are weighted in the based on annual cash dividends paid. : A fundamentally weighted index that measures the performance of the mid-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The comprises the companies that compose the top 75% of the market capitalization of the DEFA after the 300 largest companies have been removed. Companies are weighted in the based on annual cash dividends paid. : A fundamentally weighted index that measures the performance of the small-capitalization segment of the dividend-paying market in the industrialized world outside the U.S. and Canada. The comprises the companies that compose the bottom 25% of the market capitalization of the DEFA after the 300 largest companies have been removed. Companies are weighted in the based on annual cash dividends paid. (Europe, Australasia, Far East): A market cap-weighted index composed of companies representative of the developed market structure of 22 developed countries in Europe, Australasia and Japan. Mid Cap : A free float-adjusted market capitalization equity index that captures mid-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Mid Cap Value : A free float-adjusted market capitalization equity index that captures mid-cap securities exhibiting overall value style characteristics across developed market countries around the world, excluding the U.S. and Canada. Small Cap : A free float-adjusted market capitalization equity index that captures small-cap representation across developed markets countries around the world, excluding the U.S. and Canada. Small Cap Value : A free float-adjusted market capitalization equity index that captures small-cap securities exhibiting overall value style characteristics across developed market countries around the world, excluding the U.S. and Canada. S&P 500 : A market capitalization-weighted benchmark of 500 stocks selected by the Standard & Poor s Committee, designed to represent the performance of the leading industries in the United States economy. NASDAQ Achievers : Designed to measure the performance of companies in developed international markets that have increased their dividends for the past five consecutive years. Weighting is by dividend yield. NASDAQ US Achievers Select : Designed to track the performance of dividend-paying companies in the U.S. that have increased their annual dividend payments for the last 10 or more consecutive years. Dow Jones EPAC Select : Designed to measure the performance of relatively higher-yielding companies in developed market countries outside the United States that meet certain dividend criteria defined by Dow Jones. Weighting is by dividend yield. Dow Jones U.S. Select : A modified market capitalization approach that weights by dividend yield. Stocks are selected for fundamental strength relative to their peers, subject to various screens such as dividend quality and liquidity. Funds are distributed by ALPS Distributors, Inc. Jeremy Schwartz and Tripp Zimmerman are registered representatives of ALPS Distributors, Inc Investments, Inc. is a registered mark of Investments, Inc. WIS /