Investors usually embrace small-cap stocks for growth and over the course of that indulgence, they're often willing to sacrifice profitability to attain that growth. Lack of profitability is tolerated (until it's not) throughout equity markets and it's a luxury often afforded to mid-sized and large-cap growth companies, so conventional wisdom says why not apply to small caps?
Profitable or not, small caps are riskier than larger companies, but if lack of profitability is added into the equation, than the risks exponentially increase. For investors looking to dial back that risk profile while adding an element of quality to small-cap investing, the WisdomTree U.S. SmallCap Fund (NYSE: EES) is an ETF that makes a lot of sense.
EES follows the WisdomTree U.S. SmallCap Index, which only includes companies that “have generated positive cumulative earnings over their most recent four fiscal quarters prior to the index measurement date,” according to WisdomTree.
Why It's Important
The emphasis on profitability with EES does not mean investors sacrifice performance. Over the past three years, the Russell 2000 Index and the Russell 2000 Value Index are up an average of 29.25%, but EES is higher by 36% over the same span.
“Since its inception, WisdomTree’s methodology has maintained an average 12% under-weight in companies with negative earnings compared with the Russell 2000 Index,” said WisdomTree in a recent note. “The emphasis on profitable companies has been beneficial over the long term as well because WisdomTree’s methodology has outperformed the Russell 2000 Index by almost 90 basis points (bps).”
Among small caps, at least in the EES universe, cyclical sectors do not mean lack of earnings. The ETF allocates 44% of its combined weight to consumer discretionary and industrial stocks.
EES is a core fund intended for use by long-term investors. To that, the profitability focus can reduce volatility during times of elevated market turbulence, times that often impact small-cap stocks more than other market segments.
“An earnings-weighted approach to small-cap equities can also help protect on the downside during periods of heightened volatility because high-quality companies can simultaneously provide a defensive allocation,” according to WisdomTree. “During the painful fourth quarter of 2018, WisdomTree’s method managed to outperform the Russell 2000 Index by 115 bps, with its 13% under-weight in negative earners providing more than two-thirds of the advantage.”
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