One Way to Manage Small-Cap Valuation Risk

A common refrain we hear across all different types of investors is this: “U.S. equity markets are becoming expensive.”

The fact is that U.S. equity returns have been strong for an extended period, and many market analysts are thinking that they won’t be able to continue their strong run indefinitely.

What Contributed to the U.S. Rally We’ve Witnessed?

If we take a step back and assess some of the factors contributing to the strong U.S. equity run, we may be able to locate those—or at least similar—conditions beginning to show themselves in other markets. These markets could be ripe for a similar run, potentially in the future, at least if history is any guide.

• Low Interest Rates & Easy Monetary Policy for an Extended Period: The U.S. Federal Reserve (Fed) has only just begun to normalize the size of its balance sheet and raise the Fed Funds policy interest rate. Since the global financial crisis of 2008–09, there has been nearly a full decade of easy monetary conditions in the U.S., and though we don’t believe that is the sole determinant of higher equity markets, it was certainly an important factor.

• Recent Reduction in Regulations: Among the Trump administration’s policy priorities is the reduction in regulations to make it easier for firms to do business. It’s possible that less regulatory restriction could help allow productivity to rise off the very low levels we’ve seen of late. That may have the potential to extend the U.S. equity rally that has been intact for almost 10 years.

• Massive Innovation in Technology Firms: Hardly a day that goes by that at least one of the following “F-A-N-G” (Facebook-Amazon-Netflix-Google) companies isn’t mentioned. These companies have shaken up how many things—for instance, buying Thanksgiving dinner—are done. While the performance of these companies has been incredibly strong, it is very difficult to say that these firms are in a bubble akin to what we saw at other companies in the 1999–2000 period, which we now know of as the “tech bubble.”

Abenomics Might Create a Similar Set of Conditions in Japan

On December 16, 2012, Prime Minister Shinzo Abe began his tenure. Since then, over a period of almost five full years, we have seen:

• Exceptionally Easy Monetary Policy: The Bank of Japan (BOJ) saw the U.S. example from the Fed and has since taken it many steps further. For example, instead of stating a specific purchase amount of monetary expansion for each month, the BOJ has committed to buying an unlimited number of Japanese government bonds (JGBs) such that yields to the 10-Year tenor are close to 0%.¹ This is in addition to buying equities and real estate.

• Encouragement of Using Cash & Improving Corporate Governance: One of the biggest issues in Japan has been corporate governance and the lack of utilization of cash on corporate balance sheets. We’re seeing buybacks and dividends increase,² and we’re also seeing capex (which we wrote about in our “Japan GDP: Into the Sweet Spot” article accelerating.³

• Cutting Corporate Taxes: As of this writing, we’re waiting to see what, if anything, will be announced in terms of U.S. corporate tax policy changes. Notably, Japan has been lowering its corporate tax rates during the Abenomics period.⁴ 

• Massive Innovation: Japanese firms are some of the most technologically advanced in the world. We’ve seen lots of activity in health care and biotech (which makes a lot of sense with such an “old” society), as well as in other areas like ship-building.

Small Caps: Emphasize Favorable Conditions in a Given Market

Large-cap companies are becoming more and more global, so it is increasingly difficult to attribute their success or failure to activities in their country of domicile. The S&P 500 Index in 2017 is a great example—we haven’t seen much in the way of favorable fiscal policy momentum in 2017 as of this writing, but a weaker U.S. dollar has been a boon for earnings on the export side of the equation.

Similarly, in Japan, companies such as Honda, Toyota, Nissan and Panasonic are global multinationals that will be impacted by economic prospects in the U.S., Europe, China and other countries rather than solely focused on any Abenomics-related developments. Japan’s small caps tend to be much more locally focused.

Price-to-Earnings Ratios for Japan’s Small Caps Are Much Lower than for U.S. Small Caps

• The WisdomTree Japan SmallCap Dividend Index has more than 50% of its weight in firms with P/E ratios below 16.8x. The Russell 2000 only has 15.9% of its weight in such firms.

• The Russell 2000 Index has approximately 20% of its weight in firms with negative earnings over the prior 12 months. The WisdomTree Japan SmallCap Dividend Index has less than 4% of its weight in such firms.

Now, we can hear what you’re saying: “Of course that is the case. The WisdomTree Japan SmallCap Dividend Index looks significantly less expensive than the Russell 2000 Index because the Russell 2000 Index’s performance has been THAT much better over the past five years.”

Even with More than 25% Yen Depreciation, Japan’s Small Caps Factoring in Yen Weakness Still Look Strong during the Abenomics Period

• It’s hard to imagine anything outperforming the strength of U.S. small caps during the last five years, which happens to just about coincide with the Abenomics period. But even though the yen dropped by more than 25% versus the U.S. dollar, the WisdomTree Japan SmallCap Dividend Index, which is unhedged and has exposure to the weakening yen over this period, actually beat the Russell 2000 Index. It’s also beating it during 2017. The fact that the Japanese exposure is still less expensive on a P/E basis is therefore confirming that the earnings in Japan over this period have been THAT much stronger.

While the analysis presented here discusses the unhedged WisdomTree Japan SmallCap Dividend Index, we also have Indexes that neutralize the yen’s impact from equities with the same underlying basket of stocks. For those value-oriented investors looking for small-cap diversification, WisdomTree remains a big fan of Japanese small caps.

¹Source: “New Framework for Strengthening Monetary Easing: Quantitative & Qualitative Monetary Easing with Yield Curve Control,” Bank of Japan, 9/21/16.