DGS - DGS: Emerging Markets Small-Cap Dividend ETF Good Momentum And Yield Cheap Valuation

2023-11-27 11:43:20 ET

Summary

• DGS is an emerging market small-cap dividend ETF.
• The fund yields 4.5%, is cheaply valued, and has some momentum on its side.
• An overview and analysis of the fund leads me to a buy rating.

I last covered the WisdomTree Emerging Markets SmallCap Dividend Fund ( DGS ) in late 2022. In that article , I argued that DGS' good dividend yield, strong dividend growth track-record, and cheap valuation, made the fund a buy. The fund has moderately outperformed relative to the S&P 500 since, even though emerging market equities as a whole have performed quite poorly:

Since writing that article, dividends have been cut, with yields dropping to 4.5%. Dividends remain reasonably good, with positive long-term growth. Momentum seems somewhat positive, especially in comparison to other emerging market equity funds. In general terms, DGS' fundamentals remain strong, so the fund remains a buy.

DGS - Overview and Analysis

Index Methodology

DGS is an equity index ETF investing in small-cap emerging market equities with above-average yields and fundamentals. It tracks the WisdomTree Emerging Markets SmallCap Dividend Index , an index of these same securities. It is a relatively complicated index, perhaps excessively so.

The index first selects applicable securities meeting a basic set of inclusion criteria, centered on size, liquidity, location, etc. Companies with negative momentum and low quality are excluded from the index. Applicable companies ranking in the top 30% dividend yield are included in the index.

It is a dividend-weighted index: companies with higher dividend payments in total have greater weights. Larger companies tend to have higher total dividend payments than smaller ones, and higher-yielding companies tend to have higher total dividend payments than lower-yielding companies. As such, the index's weighting scheme ends up being a cross between market-cap weighting and yield-weighting.

As with most indexes, there are several other exclusion and inclusion criteria, as well as weight caps and floors meant to ensure diversification. In general terms, I find DGS' underlying index to be adequate, if perhaps a bit complicated.

Holdings

DGS provides investors with diversified exposure to its equity market niche , with investments in almost 900 securities from dozens of countries and most relevant industries.

As is the case for many emerging market funds, DGS is overweight China and Taiwan, with these two markets accounting for almost 50% of the fund's portfolio.

In my opinion, said overweight position is excessively risky, due to the risk of a Chinese invasion of Taiwan. Although I don't personally think an invasion is likely, I'm not a military analyst, and I got blindsided by the Ukraine war already.

DGS' portfolio is much more balanced on an industry basis, with investments in most relevant industries. Importantly, the fund is not significantly underweight tech, unlike most dividend equity ETFs. There is a slight tilt towards industrials and materials, two industries overrepresented in emerging market economies.

In general terms, the fund seems quite diversified within its equity market niche. Said niche is quite narrow, with emerging market equities comprising a small portion of global equity markets, and small-caps comprising an even smaller percentage within these. Most global equities are excluded from the fund, and so the fund does not provide sufficient, diversified exposure to global equities.

As an example, fund weights overlap a measly 1% with the Vanguard Total World Stock Index Fund ETF Shares ( VT ), a global equity index fund:

Same overlap with the iShares MSCI Emerging Markets ETF ( EEM ), an emerging markets equity index ETF.

Investors looking for broad-based, diversified exposure to global or emerging market equities will not find this in DGS.

As DGS' holdings are not representative of global or emerging market equity indexes, performance could materially differ from these. From what I've seen, DGS tracked broader emerging market equity indexes from 2010 to 2020, but their performance has diverged somewhat since.

In my opinion, due to DGS' niche, unrepresentative holdings, portfolio weights and position sizes should be kept relatively small. Personally, I would not go above 5%.

Valuation

DGS' core investment thesis rests on the fund's cheap valuation. It currently trades with a PE ratio of 8.6x, and a PB ratio of 1.0x. Both are incredibly low figures on an absolute basis, significantly lower than those of the S&P 500, and moderately lower than those of international and emerging market equity indexes.

International equities tend to trade with hefty discounts to U.S. equities, but these have widened as of late, and are at their highest levels in decades.

Cheap prices and valuations means comparatively higher dividends, and could lead to above-average returns, contingent on valuations normalizing. Which brings me to my next point.

Above-Average 4.5% Yield

DGS' cheap price and valuation leads to comparatively strong dividends, with the fund currently yielding 4.5%, compared to 1.6% for the S&P 500. Spreads are almost entirely the result of the fund's low price: if it traded with the same PE ratio as the S&P 500 it would only yield 2.1%. DGS' dividends are also stronger than those of global and emerging market equity indexes.

On a more negative note, the fund's dividend growth track-record is spotty. Dividends are spotty, cuts are common, and they are down almost 19% in the past twelve months. Recent cuts were partly the result of abnormally large dividends in 2022, and remain much higher than in 2021 and prior years. Long-term growth is positive, but weak.

Overall, DGS' dividends are reasonably good in my opinion, and an advantage of the fund relative to most equity index funds. Due to dividend volatility and weak long-term growth these are not a significant advantage, however.

Performance Track Record

DGS' performance track-record is decisively mixed, but I do believe that the positive aspects point towards strong future returns and outperformance.

DGS has significantly underperformed relative to the S&P 500 since inception. Underperformance was almost entirely due to emerging market equity underperformance in the 2010s. Emerging market equities had much stronger returns in the prior decade, the 2000s, but DGS did not exist for most of said time period. It did exist during the financial crisis, and suffered attendant losses.

Although DGS' long-term performance is quite terrible, there are a few silver linings and exculpatory factors. The fund's timing was terrible, being created at the tail-end of significant emerging market outperformance. Returns are generally moderately higher than those of broader emerging market equity indexes, slightly higher than those of international indexes. Finally, returns have materially improved since early 2022, with the fund outperforming the S&P 500 during the period.

Moving forward, I expect stronger returns from DGS, as fund and emerging market fundamentals have significantly improved.

As mentioned previously, valuations are cheaper now than in prior decades.

Dividend yields are higher too:

As are dollar prices:

DGS' returns were much weaker when the fund traded with a small discount and low yield, but have improved considerably since yields and discounts rose. Both remain reasonably high, so I expect returns will remain strong moving forward as well.

Conclusion

DGS' above-average 4.5% yield, cheap valuation, and good momentum, make the fund a buy.

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