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June Issue Of Hidden Value Stocks

NOTE: Existing members can skip to the bottom to find the full 20-page issue.

We asked a ton of ValueWalk readers what their #1 goal was for improving their value investing.

Can you guess what they said?

No, it wasn’t more coverage of Apple or Tesla, those are already well covered by the likes of CNBC, sell side firms and blogs.

Nor was it more coverage of risky leveraged trades, ETNs.

They wanted good small-cap investment ideas that are vetted and have liquidity, but not well covered by Wall Street, Bloomberg, CNBC, sell-side analysts, blogs or even closed sites like SumZero or Value Investing Club.

This answer makes sense: we all want to collect more winners in our portfolio.

But after following investments of ultra-famous investors (Buffett, Dalio, Icahn), reading diligently through 10-Qs at night, and even combing through article after article on obscure forums and blogs, it can be hard to find qualified “special situation” ideas that aren’t already widely known.

So, to meet this key need of our readers, ValueWalk launched the Hidden Value Stock newsletter.

The Hidden Value Stock newsletter is a 20+ page deep dive report that gives you detailed analysis behind specific small and mid cap stocks that two under-the-radar value investing hedge funds like, as well as interviews with the fund managers about their investing process.

The latest issue of Hidden Value Stocks is out this week and if you want to sign up to receive an issue.

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The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

This is part five of a ten-part series on small-cap investing.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

 

For the other parts of this series please follow the links below:

So far in this series, I’ve looked at the academic research on small-cap investing but while academic research is always interesting, it’s no substitute for real-world experience. With that being the case, in the next few parts, I’m going to explore some tips, tricks, and experiences from the world’s most successful small-cap investors.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s rules   

Peter Lynch is without a doubt the most successful small-cap investor to have ever lived. Anyone can generate 20%+ p.a. returns from small-caps for a few consecutive years but few have been able to establish a record similar to that of Lynch.

The Small-Cap Investing Handbook Part Five: Peter Lynch’s Rules

While managing the Fidelity Investments Magellen Fund, Lynch produced an average annual return for investors of 29.2% between 1977 and 1990, double the return of the S&P 500 over the same period, and catapulting the fund into the ranks of the best performing fund in the world. No doubt, if Lynch had continued to manage the fund throughout the 90s during the great dot-com bull run, the fund’s long term returns would be even more impressive.

As well as managing Magellen, Lynch also wrote several books on the topic of investing and these timeless investing books have really helped cement his reputation as one of history’s greatest investors. Within these books, Lynch made it extremely apparent that the average investor has what it takes to beat Wall Street at its own game and by following a few simple rules, investors could make money from small caps.

These 25 (26) Golden Rules Of Investing, are printed at the end of Lynch’s book, Beating the Street and no series on small-cap investing would be complete without them.

So, without further ado here are Peter Lynch’s 25 Golden Rules Of Investing:

  1. Investing is fun, exciting, and dangerous if you don’t do any work.
  1. Your investor’s edge is not something you get from Wall Street experts. It’s something you already have. You can outperform the experts if you use your edge by investing in companies or industries you already understand.
  1. Over the past three decades, the stock market has come to be dominated by a herd of professional investors. Contrary to popular belief, this makes it easier for the amateur investor. You can beat the market by ignoring the herd.
  1. Behind every stock is a company, find out what it’s doing.
  1. Often, there is no correlation between the success of a company’s operations and the success of its stock over a few months or even a few years. In the long term, there is a 100 percent correlation between the success of the company and the success of its stock. This disparity is the key to making money; it pays to be patient, and to own successful companies.
  1. You have to know what you own, and why you own it. “This baby is a cinch to go up!” doesn’t count.
  1. Long shots almost always miss the mark.
  1. Owning stocks is like having children – don’t get involved with more than you can handle. The part-time stock picker probably has time to follow 8-12 companies, and to buy and sell shares as conditions warrant. There don’t have to be more than 5 companies in the portfolio at any time.
  1. If you can’t find any companies that you think are attractive, put your money into the bank until you discover some.
  1. Never invest in a company without understanding its finances. The biggest losses in stocks come from companies with poor balance sheets. Always look at the balance sheet to see if a company is solvent before you risk your money on it.
  1. Avoid hot stocks in hot industries. Great companies in cold, no growth industries are consistent big winners.
  1. With small companies, you’re better off to wait until they turn a profit before you invest.
  1. If you’re thinking about investing in a troubled industry, buy the companies with staying power. Also, wait for the industry to show signs of revival. Buggy whips and radio tubes were troubled industries that never came back.
  1. If you invest $1,000 in a stock, all you can lose is $1,000, but you stand to gain $10,000 or even $50,000 over time if you’re patient. The average person can concentrate on a few good companies, while the fund manager is forced to diversify. By owning too many stocks, you lose this advantage of concentration. It only takes a handful of big winners to make a lifetime of investing worthwhile.
  1. In every industry and every region of the country, the observant amateur can find great growth companies long before the professionals have discovered them.
  1. A stock-market decline is as routine as a January blizzard in Colorado. If you’re prepared, it can’t hurt you. A decline is a great opportunity to pick up the bargains left behind by investors who are fleeing the storm in panic.
  1. Everyone has the brainpower to make money in stocks. Not everyone has the stomach. If you are susceptible to selling everything in a panic, you ought to avoid stocks and stock mutual funds altogether.
  1. There is always something to worry about. Avoid weekend thinking and ignore the latest dire predictions of the newscasters. Sell a stock because the company’s fundamentals deteriorate, not because the sky is falling.
  1. Nobody can predict interest rates, the future direction of the economy, or the stock market. Dismiss all such forecasts and concentrate on what’s actually happening to the companies in which you’ve invested.
  1. If you study 10 companies, you’ll find 1 for which the story is better than expected. If you study 50, you’ll find 5. There are always pleasant surprises to be found in the stock market – companies whose achievements are being overlooked on Wall Street.
  1. If you don’t study any companies, you’ll have the same success buying stocks as you do in a poker game if you bet without looking at your cards.
  1. Time is on your side when you own shares of superior companies. You can afford to be patient – even if you missed Wal-Mart in the first five years, it was a great stock to own in the next five years. Time is against you when you own options.
  1. If you have the stomach for stocks, but neither the time nor the inclination to do the homework, invest in equity mutual funds. Here, it’s a good idea to diversify. You should own a few different kinds of funds, with managers who pursue different styles of investing: growth, value, small companies, large companies, etc. Investing in six of the same kind of fund is not diversification.
  1. The capital gains tax penalizes investors who do too much switching from one mutual fund to another. If you’ve invested in one fund or several funds that have done well, don’t abandon them capriciously. Stick with them.
  1. Among the major markets of the world, the U.S. market ranks eighth in total return over the past decade. You can take advantage of the faster-growing economies by investing some of your assets in an overseas fund with a good record.
  1. In the long run, a portfolio of well-chosen stocks and/or equity mutual funds will always outperform a portfolio of bonds or a money-market account. In the long run, a portfolio of poorly chosen stocks won’t outperform the money left under the mattress.

The Small-Cap Investing Handbook Part Four: Quality Over Quantity

This is part four of a ten-part series on small-cap returns.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

Also see

Handbook Part Four: Small-cap investing returns

As covered in the first three parts of this series, there is plenty of evidence which shows that small caps outperform their large cap peers but not on an aggregate basis.

The small-cap premium has disappeared since it was first discovered in 1980, but some small-cap stocks, particularly those that are high quality, continue to outperform. As covered in part three, these rare breed stocks are difficult but not impossible to find, and the rewards on offer certainly justify the additional work required to find these hidden gems.

A November 2015 Research Affiliates article by Vitali Kalesnik and Noah Beck succinctly summarizes small-cap investing as, “Small caps are not the fish, they are the fishing spot—not the source of alpha, but rather a place where alpha can be found.” This is, I believe, one of the most accurate ways of describing the small-cap market based on everything I have read so far. However, it is imperative for investors to understand the need to appreciate quality when looking at small caps, something Kalesnik and Beck’s article goes into detail on.

One of the metrics the duo considers is the distress and volatility characteristics of stocks by size. Using data from 1988 to 2014, the researchers find that the S&P credit rating difference between small-cap stocks (B rated) and large cap stocks (A+ rated) indicates the higher likelihood (over 200 times) of smaller stocks being delisted, often because of default.

Unsurprisingly, portfolio volatility for the firms with the lowest credit ratings is also higher at 20.6% compared to 14.3% for the larger companies with a higher credit rating. Small caps have a delisting rate of 2.38%, 23,700% times greater than that of large caps’ delisting rate of 0.01%. Volatility too is much greater in the small-cap arena when you dig below the surface. The article notes:

“A comparison of the median stock volatility of the highest and lowest quintiles is significantly more striking: the median volatility of the smallest stocks (50.5%) is almost 100% more volatile than the median volatility of the largest stocks (25.5%). Also, the dispersion in stock volatility is much greater for small stocks than for large stocks, with a 25th–75th percentile range of 32.1%–76.0% compared to 19.8%–33.2%, respectively.”

Small-cap returns are worth the risk

This additional volatility and risk of bankruptcy is worth trying to navigate thanks to the higher returns on offer from (high quality) small caps. So far in this series, we’ve seen evidence which shows that the small-cap premium exists, although there’s been little in the way of discussion as to why this premium exists. The Kalesnik and Beck article attempts to answer this question by taking a look at the average bid–ask spreads for each of the size quintiles over the period 1988–2014. The bid–ask spread serves as a proxy for trading costs. Higher trading costs reduce the attractions of equities; some investors will avoid stocks with high bid-ask spreads altogether as it severely limits profitability.

A stock with a spread of 5% instantly gives you a loss of 5% after the initial purchase excluding dealing costs, which is unpalatable to investors. Institutional investors also avoid such equities as the widespread and illiquid market means it’s difficult to build a position. Longer term investors, however, have no need to worry about a 5% spread — especially if they are targeting gains of 100% to 200% in the long term.

Still, Kalesnik and Beck find in their article that over the 27 year period studied, the average bid-ask spread for the smallest quintile of the market averaged 4.56%, compared to a spread of 0.46% for the largest quintile. These findings go some way to explaining why the small-cap premium exists and why it is possible to find more mispriced securities in this area of the market than any other.

The authors of the Research Affiliates small-cap article go on to look at the performance of value strategies in large-cap and small-cap universes between 1967 and 2014, and what they find only supports the conclusion that small-cap strategies do outperform but to achieve the best results you have to focus on quality.

The figures show that by using a traditional price-to-book value strategy for large caps over the period studied, investors were able to achieve a return of 13.1% per annum. The same approach used for small caps produces the return of 16.6%. However, where small caps really show the greatest level of outperformance is on the cash flow-to-price value (and quality) metric.

Using this ratio to screen market produced a return of 17% per annum for value small caps, compared to 13% for large-cap peers. What’s more, for the long-short study, the t-stat of the cash flow-to-price metric was significant the 1% level. More evidence that quality small-cap returns are the key to outperformance.

Small-Cap Investing: Quality Over Quantity all-cap returns

The Small-Cap Investing Handbook Part Three: Size Matters

This is part three of a ten-part series on small-cap investing and the small-cap premium.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small-cap investing magazine Hidden Value Stocks.

  1.  Handbook Part One: Introduction
  2.  Handbook Part Two: The Premium

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

 

small-cap premium The Small-Cap Investing Handbook Part Three: Size Matters – small-cap premium

As covered in parts one and two of this series, there has been some debate as to whether or not the small-cap premium (whereby small-cap stocks outperform their larger peers) still exists. Some studies appear to show that this effect has disappeared but a paper entitled “Size Matters If You Watch Your Junk” by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 confirms that the small-cap premium does still exist for high-quality companies.

 

Small caps are known to be high-risk investments, which is why no one expects every single small-cap to outperform. With this being the case, a study looking at the performance of high-quality small caps may be the best way of trying to understand whether or not the small-cap premium does still exist.

The authors of the paper separate the good companies from the “junk” by using several simple measures of “quality” which they described in an earlier paper. These measures are:

“Profitability (margins, free cash flow, profits per unit of book value, etc)

The 5-year growth rate in profits (again using a broad range of measures of earnings)

“Safety”, which is based on both the volatility of the stock, the volatility of the underlying profits, and the amount of leverage

How much profit is returned to shareholders rather than retained or spent, with higher payout ratios signifying higher “quality”

Separating small caps according to these factors produces some astonishing results. The authors found that around one-third of the smallest companies in the sample fall in the bottom of the rankings when it comes to things like profitability, sales growth, and earnings volatility. Overall, the typical small-cap company has far worse fundamentals than the average company in the broader stock market universe with a less than 10% of the small caps considered between 2010 and 2012 actually meeting high-quality standards. As the chart below shows, most of the firms with the worst fundamentals are small.

 

In comparison, around 40% of the largest firms in the top quintile of all publicly traded shares are of high quality according to the study.

These findings go a long way to explaining why the small-cap premium has been difficult to find in academic studies which do not compensate for quality. The final findings of “Size Matters If You Control Your Junk” should settle the argument once and for all. The alpha (risk-adjusted annual return) to a strategy of buying small stocks and shorting large ones, ignoring quality, is 1.7%/year (t-stat of 1.23). This becomes 5.9%/year (t-stat of 4.89) controlling for quality. It’s hard to argue with those numbers.

Quality investing shouldn’t be confined to just small-caps. Research has shown that most stocks return nothing over their lifetime, which is bad news for investors who believe they can replicate Warren Buffett’s success by using an extremely concentrated portfolio.

The figures supporting this conclusion come from research by Arizona State University finance professor Hendrik Bessembinder, who studied the returns of 26,000 equities over the period of 1926 to 2015. He found 96% of stocks achieved nothing.

During this period, $31.8 trillion of wealth was created but just 4% of equities. Of the total, Apple Inc. accounted for about 2% of wealth creation between 1926 and 2015. ExxonMobil Corp. accounted for 3% of the wealth created.

This isn’t just a lesson for small-cap investors. It is a warning for investors across the board if you want to outperform then quality matters.

What’s more, if you’re willing to take on the extra work and dig deeper to find the market highest quality small caps, then there is evidence to support the conclusion that small caps will outperform the market over time. However, the small-cap universe as a whole should not be counted on to outperform the rest of the market.

The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

This is part two of a ten-part series on small-cap investing discussing the small-cap premium.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

 

The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

Evidence of a small-cap premium first appeared in 1980 when a study titled “The Relationship Between Return And Market Value Of Common Stocks” was first published. Since publication, this study has formed the basis of a number of other academic studies that have tried to prove the existence of the small-cap premium.

Today investors are increasingly asking if this study remains relevant considering how the markets have developed since the late 70s. Not only has information on small caps become more widely disseminated but trading in these instruments is now easier than ever.

According to research conducted by Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University, while a small-cap premium may have existed between 1928 and 1979 when the above study was published in 1980, it seems all of the excess small-cap returns evaporated.

Professor Ken French’s data library (on small-cap stocks) shows between 1926 and 1980, small-cap stocks earned on average of 7.18% more than the market each year. Immediately after 1980, the small-cap stock premium appears to have disappeared.

Between 1981 and 2014, small-cap stocks earned on average 0.18% less than the market each year. The dissemination of information certainly has something to do with this trend so do wider macroeconomic variables. For example, small caps outperformed large caps by more than 40% in 2002, after the dot-com bubble burst and by 60% in 1967. The best year on record for small-cap stocks was outperformance of 80% towards the end of the second war. The periods between these outlier events have been dominated by underperformance or moderate outperformance of 10% or less.

small-cap investing small-cap premium
small-cap premium

Still, even though Ken French’s data shows the small-cap premium is not a regular occurrence, it does demonstrate that it exists.

Further evidence of the small-cap premium can be found in a study titled “The Disappearing Size Effect” although this particular study finds that any small-cap premium disappears for companies with a market capitalization of over $5 million.

“During the period 1963–1981, we find an annualized return difference between small and large firms over 13% compared to a negative 2% return differential since 1982. Removal of the smallest firms (less than $5 million market value) eliminates any statistically significant size effect during the sample period using a regression framework.”

The studies appear to question the existence of the small-cap premium, but they fail to answer one fundamental question: what happens if you remove the junk?

Watch your junk

Small caps are naturally risky, and the majority of them flame out, but famous small-cap investors such as Peter Lynch and Warren Buffett made a name for themselves by buying the best small caps and ignoring the junk. With this in mind, a paper by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 tried to answer this key question.

The researchers find that the existing criticisms of the small-cap premium do hold true in most cases. The size factor, a weak historical record of performance in the US, and even more inadequate record internationally “makes the size effect marginally significant at best.” The authors also acknowledge that long periods of poor performance, the difficulty of investing in micro-cap stocks and the concentration of small returns in January make the small-cap premiums existence difficult to justify.

Nonetheless, the paper goes on to note that the majority of the studies on the topic of the small-cap premium so far “load strongly and consistently negative on a large variety of “quality” factors.”

As determined in the paper Quality Minus Junk, following from the Gordon Growth Model, quality stocks are safe, profitable, growing, and have high payout ratio and outperform junk stocks over the long term.

Stocks with very poor quality (i.e., “junk”) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality. By controlling for junk, the authors of this small-cap study find that a robust size premium is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012.

The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

This is part two of a ten-part series on small-cap investing discussing the small-cap premium.

Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.

When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.

The series is a collaboration between ValueWalk and ValueWalk’s new small cap investing magazine Hidden Value Stocks.

Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.

 

The Small-Cap Investing Handbook Part Two: The Small-Cap Premium

Evidence of a small-cap premium first appeared in 1980 when a study titled “The Relationship Between Return And Market Value Of Common Stocks” was first published. Since publication, this study has formed the basis of a number of other academic studies that have tried to prove the existence of the small-cap premium.

Today investors are increasingly asking if this study remains relevant considering how the markets have developed since the late 70s. Not only has information on small caps become more widely disseminated but trading in these instruments is now easier than ever.

According to research conducted by Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University, while a small-cap premium may have existed between 1928 and 1979 when the above study was published in 1980, it seems all of the excess small-cap returns evaporated.

Professor Ken French’s data library (on small-cap stocks) shows between 1926 and 1980, small-cap stocks earned on average of 7.18% more than the market each year. Immediately after 1980, the small-cap stock premium appears to have disappeared.

Between 1981 and 2014, small-cap stocks earned on average 0.18% less than the market each year. The dissemination of information certainly has something to do with this trend so do wider macroeconomic variables. For example, small caps outperformed large caps by more than 40% in 2002, after the dot-com bubble burst and by 60% in 1967. The best year on record for small-cap stocks was outperformance of 80% towards the end of the second war. The periods between these outlier events have been dominated by underperformance or moderate outperformance of 10% or less.

small-cap investing small-cap premium
small-cap premium

Still, even though Ken French’s data shows the small-cap premium is not a regular occurrence, it does demonstrate that it exists.

Further evidence of the small-cap premium can be found in a study titled “The Disappearing Size Effect” although this particular study finds that any small-cap premium disappears for companies with a market capitalization of over $5 million.

“During the period 1963–1981, we find an annualized return difference between small and large firms over 13% compared to a negative 2% return differential since 1982. Removal of the smallest firms (less than $5 million market value) eliminates any statistically significant size effect during the sample period using a regression framework.”

The studies appear to question the existence of the small-cap premium, but they fail to answer one fundamental question: what happens if you remove the junk?

Watch your junk

Small caps are naturally risky, and the majority of them flame out, but famous small-cap investors such as Peter Lynch and Warren Buffett made a name for themselves by buying the best small caps and ignoring the junk. With this in mind, a paper by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 tried to answer this key question.

The researchers find that the existing criticisms of the small-cap premium do hold true in most cases. The size factor, a weak historical record of performance in the US, and even more inadequate record internationally “makes the size effect marginally significant at best.” The authors also acknowledge that long periods of poor performance, the difficulty of investing in micro-cap stocks and the concentration of small returns in January make the small-cap premiums existence difficult to justify.

Nonetheless, the paper goes on to note that the majority of the studies on the topic of the small-cap premium so far “load strongly and consistently negative on a large variety of “quality” factors.”

As determined in the paper Quality Minus Junk, following from the Gordon Growth Model, quality stocks are safe, profitable, growing, and have high payout ratio and outperform junk stocks over the long term.

Stocks with very poor quality (i.e., “junk”) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality. By controlling for junk, the authors of this small-cap study find that a robust size premium is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012.

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