In the long-term academic research, one important conclusion has dictated an enormous amount of capital allocation preferences: the historical tendency for small-cap value
stocks to outperform small-cap growth
stocks. Small-cap growth has been a fairly poor-performing long-run asset class, and over the last 50 years, small-cap value has outperformed small-cap growth by 7.6% per year.1
Why has this occurred? One simple explanation could be that people have been overexcited by the growth prospects of small-cap growth companies and effectively paid too much for the future growth options (think lottery ticket-type payoffs). In contrast, the small-cap value category is characterized by too pessimistic an outlook and people underpricing the potential of those stocks.
A Preference for Growth
In today’s world, growth is scarce, and there is a preference for companies that can achieve above-subnormal growth. Growth indexes have been outperforming value for much of the last decade—driven in part by the financial crisis that caused a deep underperformance of value strategies from 2007 to 2009.2
Should investors for the foreseeable future forget their bias to allocate more to small-cap value in favor of growth in a low-growth world? The analysis below helps illustrate one of the high hurdles that comes with small-cap growth strategies.
Small-cap companies are almost constantly issuing shares to fund their growth, much more than large-cap companies. In the U.S., large-cap companies have been displaying fairly consistent 2% net buyback yields
in recent years.3
The Buyback Difference: Small vs. Large
Large-cap stocks had a net buyback yield of 1.3%, while small-cap stocks had a net buyback yield of -2.3% on average over the last 15 years.
Net Buyback Yields: Large Cap vs. Small Cap
In small caps, there is a large difference in the buyback yields of companies with high valuations
(either companies losing money and needing to raise capital to fund their existence or companies selling at high price-to-earnings [P/E] ratios
) compared to profitable companies and lower-priced companies.
Over the last three years, the high-priced small-cap stocks had an average net buyback yield of -5.5%, meaning there was a net capital issuance, and therefore a per-share
drag of over 5% per year that they must overcome to drive future per-share earnings growth. When an investor selects just profitable companies and weights them by their Earnings Streams
, the average buyback yield has been slightly positive over this same period.4
That was one net benefit of selecting and weighting universes by profits—you got an average improvement of almost 6 percentage points per year for the net buyback yields. One critical reason this occurred was the shift to lower-priced companies within that small-cap universe and the shift away from higher-priced stocks, which are doing the most capital raising. Managers are often responding to incentives: If they think their stocks are low priced, they are issuing fewer shares, whereas companies with higher valuations issue more stock and thus have a higher per-share
hurdle to overcome.
Small-Cap Dividend Growers Were Also Higher Net Buybackers
The WisdomTree U.S. SmallCap Quality Dividend Growth Index
(small-cap dividend growers), which selects companies based on high return on equity (ROE)
, high return on assets (ROA)
and high earnings growth expectations
, raised the net buyback yield even further. In contrast to the 5.9% net share issuance over the last year from the expensive small-cap stocks, the small-cap dividend growers had a 2.37% net buyback yield (over a 8-percentage-point differential).5
The net issuance that is taking place in this small-cap expensive-stock universe is one of the reasons I believe the small-cap growth category has a tough time outperforming the small-cap value category over time.
Companies that are constantly issuing shares have to achieve a higher growth rate to overcome the dilution from raising shares outstanding. The companies in our SmallCap Quality Dividend Growth Index are actually reducing their shares outstanding and are priced in such a way that expectations are lower and easier to overcome.
In a world in which growth is scarce, the WisdomTree U.S. SmallCap Quality Dividend Growth Index represents an interesting mix of both relatively attractive current dividend
levels (especially compared to market cap-weighted
indexes) and currently more attractive net buyback yields that could support per-share earnings growth. I believe this makes a powerful case for why these stocks could perform comparably well across time.
Small-Cap Net Buyback Yields
Source: Fama & French, 3/31/1966–3/31/2016. Click here
for more information about their methodology. The portfolios, which are constructed at the end of each June, are the intersections of 2 portfolios formed on size (market equity, ME) and 3 portfolios formed on the ratio of book equity to market equity (BE/ME). Small Cap Value would be the smallest 50% by ME and the highest 30% by BE/ME. Small Cap Growth would be the smallest 50% by ME and the lowest 30% by BE/ME.
Sources: WisdomTree, Bloomberg, 4/30/06–4/30/16. References the MSCI ACWE Growth Index
outperformance of MSCI ASWI Value Index
A company’s net share buyback is the difference between the capital raised by issuing new shares and the money the company spent on buying back any outstanding shares. A positive net share buyback means that more was spent on buying back existing shares than received from issuing new shares. Net buyback yield is the amount of a company’s net buybacks divided by its market capitalization. Please note that net buyback yield does not represent a dividend paid by the company.
High-priced small-cap stocks refer to the 50% highest-priced stocks from a P/E perspective within the small-cap stock universe. Small-cap profitable stocks weighted by Earnings Stream
refers to the WisdomTree SmallCap Earnings Index
Sources: WisdomTree, FactSet, as of 3/31/16.