The large-cap S&P 500 turned in another impressive performance in 2021, outpacing both mid- and small-cap stocks along the way.
Still, smaller stocks were admirable performers as the S&P MidCap 400 and S&P SmallCap 600 indexes returned 24.7% and 26.6%, respectively, last year. Some strategies addressing these segments of the market capitalization spectrum delivered even better returns and some even beat the S&P 500, which is no small feat.
One of the reasons, perhaps the primary one, mid- and small-cap stocks delivered in 2021 is dividends. That's likely to surprise clients, many of whom don't readily associate smaller stocks with dividends. Good thing they have advisors because without such relationships, they might not be aware of the payout potency with smaller equities.
Consider this: The average return of Russell MidCap Index excluding dividend payers was nearly 7% as of Nov. 30, 2021. Bring the dividend stocks into the mix, and that benchmark was up 19.6% through the first 11 months of 2021. Yes, dividends matter.
Cash Will Be King in 2022
A primary reason mid- and small-cap dividend payers delivered sound performance last year is free cash flow. As in many of these companies generate impressive amounts of free cash flow while their non-dividend counterparts do not. Investor interest cash flow-generating accelerated later in 2021.
“The WisdomTree U.S. MidCap Dividend Index was a prime beneficiary of this flight to cash flows. Through December 15, the Index has outperformed the most widely tracked mid-cap core and value Indexes this year (2021),” says WisdomTree analyst Matt Wagner.
Returns confirm quality and cash flow made a difference with mid caps in 2021. The aforementioned WisdomTree benchmark gained 30.3% last year, beating the S&P MidCap 400 and S&P 500 by 560 and 160 basis points, respectively.
A similar phenomenon is at play with small caps – an asset class where it's often tricky to unearth profitable companies, let alone those generating free cash flow.
“The WisdomTree U.S. SmallCap Dividend Index has a comparable investment process for the small-cap universe,” adds Wagner. “Through December 15, the Index has heavily outperformed the Russell 2000 and CRSP U.S. Small Cap indexes—both indexes that skew toward larger market-cap companies—but has lagged value indexes tilted toward higher beta companies.”
Valuation Conundrum Solved
Typically, clients, and advisors for that matter, associate smaller stocks with higher valuations. Historically, that's true, particularly with small caps. However, the S&P 500 isn't particularly inexpensive today. Not even close.
Conversely, the two WisdomTree indexes highlighted here are attractively valued and offer other compelling traits.
“With elevated valuations in large-cap U.S. equities, mid- and small-caps look more attractively valued for long-term focused investors,” concludes Wagner. “And as the Fed is expected to raise interest rates multiple times in 2022, we may see more of the same in terms of outperformance of mid- and small-value stocks relative to the unprofitable story stocks that outperformed in 2020.”