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Vardy's View: Emerging Market Small Caps

11/14/2016 8:00 am EST

Focus: ETFs

Nicholas Vardy

Editor, Oxford Wealth Accelerator

Our latest recommendation combines two investment themes that both offer high potential — small-cap stocks and emerging markets, suggests Nicholas Vardy, editor of The Alpha Investor Letter.

First, a small cap tilt takes advantage of the well-known “small-cap effect” — the phenomenon that small-cap stocks outperform large caps over the long term.

Second, small caps offer a more direct play on local consumer sectors and local economies, providing greater growth and investment potential than the large-cap stocks represented in mainstream emerging markets indexes.

Third, there is the issue of seasonality. The fourth quarter is when the world’s large institutional money places its bets on the asset classes of its choice in 2017, which can lead to a big pop in the asset class at this time.

The big picture case for emerging markets is compelling, as developing countries account for an ever-growing portion of the world’s economy, population and GDP growth.

The rise of the emerging markets consumer is a global megatrend that will generate profits for companies — and their investors — for decades to come.

Meanwhile, the P/E of emerging markets stands at 11.63 and a book value of 1.54. That’s a discount of about 40% from the S&P 500.

Mainstream ETFs favor large companies. In contrast, the WisdomTree Emerging Markets SmallCap Dividend (DGS) invests in companies whose profits are driven by domestic demand, such as consumer-related companies, industrials, real estate and financial services.

Since its inception in 2007 through June 30, 2016, DGS beat approximately 93% of funds in the emerging markets category.

Once you’ve made the arguments on growth potential, valuation and the small-cap effect, there remains one crucial factor in betting on emerging markets. And that is the timing.

Emerging markets have been characterized by so many false dawns that most investors have just given up on them.

So why do I think now is the time for emerging markets? Investment committees make their annual asset allocation decisions in November and December for the following year.

Absent a global slowdown, it is likely that this process will be repeated this year. Once it becomes “okay” to invest in emerging markets, more money will flow into them, thereby driving both prices and interest up.

In short, betting on the WisdomTree Emerging Markets SmallCap Dividend Index is a bet on emerging markets coming back into fashion. And based on this year’s strong performance, 2017 just may be that time.

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By Nicholas Vardy, editor of The Alpha Investor Letter

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