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

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.

Bluetower Q1 Letter

Blue Tower Asset Management  is off to a slower start in 2017 but had a monster 2016 with an impressive 35% return. Check out our exclusive interview with the PM on some of the hedge fund’s favorite small caps.

Also see Livermore Partners up 85% in 2016 (also profiled here)

The Global Value strategy returned -2.90% gross (-3.14% net) for Q1 2017. Our performance this quarter was somewhat weak primarily due to three factors: 1) relative weakness in US small-cap equities, 2) a sentiment-driven sell off in EZCORP’s stock, 3) a general meltdown in the subprime auto lending sector. In this letter, I will give updates on EZCORP’s business and our investments in auto lending.

Blue Tower Asset Management

Blue Tower Asset Management – Relative Weakness in small-caps

Smaller companies had a rougher start to the year than the overall market. The Russell 2000, an index of smaller companies that (as of the most recent reconstitution) have market capitalizations between $3.9 billion and $133 million, had a return of 2.47% in Q1 relative to 6.07% for the S&P 500. If I were to speculate on the origin of the relative weakness of small cap stocks, I believe it is the result of the tremendous post-election rally that small cap stocks had after the election. This post-election bump in small caps was largely due to the belief that US corporate tax reform would be forthcoming (Trump campaigned on lowering the corporate tax rate to 15%). Small companies in the US pay a higher effective tax rate than large caps stocks, with the average for the Russell 2000 and the S&P500 being 30.6% and 25.8% respectively1. As hopes for a rapid tax reform process dim, Russell 2000 stocks have pulled back. Due to the Blue Tower Global Value strategy historically being invested mostly in US small cap stocks, the Russell 2000 has been the most correlated of the major indices to the strategy.


EZCORP (EZPW) was the largest detractor to our performance in Q1 2017 with a performance impact of -4.5%. EZCORP has gone through significant changes since we first invested. Late last year, they sold Grupo Finmart, their Mexican government employee payday lending service. The company recently had their annual shareholder meeting in Austin, TX where the company’s leadership discussed the growth in pawn loans outstanding and other aspects of the business. Over the past year, the company has grown loans in the US faster than either of their two major competitors. They are also undergoing a major hiring push and switching their workforce towards being fulltime only and phasing out many part time roles. They explained that they believe that fulltime employees will give the company less turnover which will allow them to gain more experience and create a better customer experience.

The creation of a new point of sale system for EZPW is a major initiative for the company. EZPW is developing the new system in-house with a software development team in Austin and has already invested $3 million into the project. This system will use the individual history of each borrower to determine the relative likelihood that the borrower will repay their pawn loan. For individuals who are more likely to pay back the loan, EZPW can give a larger loan and therefore boost the balance upon which they are collecting interest. For those who are less likely to pay back their loans, EZPW can give a smaller loan and thereby lower the cost of their merchandise and boost their gross margin. The point of sale software will provide store staff with a minimum and maximum loan amount for each item used as collateral allowing them to still make adjustments based on their judgement. If well implemented, such a system could give it a significant advantage over other pawn chains.

The company is also doing a major refurbishment of their stores due to significant deferred maintenance. For example, the company mentioned during the annual meeting that one store had pot holes in its parking lot. This reinvestment should improve the experience for customers and borrowers as well as increase the morale of employees.

Blue Tower Asset Management

Charlie Munger once said in response to a question about the power of incentives: ‘I think I’ve been in the top 5% of my age cohort all my life in understanding the power of incentives, and all my life I’ve underestimated it. And never a year passes but I get some surprise that pushes my limit a little farther.’ The incentive structure of any company’s management is important towards understanding their behavior, and this is certainly true for EZCORP.

It’s important to note that several of the senior executives at the company left far larger corporations to work at EZCORP. For example, Stuart Grimshaw, the Executive Chairman, was previously the CEO of the Bank of Queensland, an Australian bank with a market capitalization of $3.5 Billion US Dollars. For them to leave larger companies, they must have seen an opportunity to make more money off of their EZPW equity.
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Arquitos Capital Up 30% CAGR On 5 Year Fund Anniversary

We profiled Steve Kiel in our latest edition and he is killing it yet again. See his Q1 letter below and find the full issue here.

Also see

Arquitos Capital Up 55% In 2016 (28% CAGR) Amid Big

Hedge Fund Interview: Steven Kiel: Arquitos Capital … –

Arquitos Capital Partners returned 17.6% net of fees in the first quarter of 2017. Please see page four for more detailed performance information.

We celebrated the fund’s five year anniversary on April 10. During that time period, we returned 30.9% annually net of fees, beating the S&P 500 by 17.2% per year and the HFRI Index, an index that broadly measures the performance of all hedge funds, by 26.9% per year. Before fees, the fund returned 38.8% annually.

Arquitos provided positive returns in four out of five years and beat the market four out of five years. $100,000 invested at the outset is now worth $384,750. At that pace, your money has doubled every two years and seven months.

Do not expect these astronomical gains to continue. We had a variety of things working in our favor. First, the market was up each year during this time period. The S&P 500 itself performed very well, netting 13.7% per year with dividends reinvested. While I have tried to invest in companies outside of the mainstream, we have still ridden a strong wave.

Second, we are small. Assets under management today are $11 million. They were far smaller when we started and along the way. In the investment world, we are a speck. A brightly burning one, for sure, but still not much more than a piece of dust. Right now and since the launch of the fund, we have had the ability to make an investment in nearly any public company no matter the size. As assets grow, some of those companies will be too small for us to make a meaningful investment. My philosophy and approach will stay the same, but at some point the universe of opportunities will begin to shrink. We are not yet to that point, and may not get there for some time, but it will happen and it will have an effect on returns.

In my first letter to you in 2012 I wrote about the partnership that Warren Buffett ran from 1957 to 1968. He beat the markets by about 16% per year and returned 25.3% per year to investors, with no down years, I might add. We simply will not beat that performance over the lifetime of our fund.

The great thing is that because of the power of compound interest, we only have to do a fraction of our past performance in order to do well in the future. Compounding at 10% per year makes an initial $100,000 investment worth about $673,000 in 20 years and $1.75 million in 30 years. That is a tremendous gain. The keys for compounding are getting started and patience.

When I started the fund I knew we would do well. A fundamental value strategy focused on long term results promised that. It turns out that trying to not lose money gives you a big advantage over the competition. I did not strive for this performance by taking risks. It came from investing in companies that I understood, companies that generally had strong balance sheets and low risk of permanent capital loss, and situations where the markets did not fully recognize attractive aspects of the business. We will continue to do well by taking this approach.

Arquitos Capital Partners 3Q16 Investor Letter; Up 14.6 ..

While I write these letters and provide performance returns each quarter, and you get investor statements monthly, this is far too short of a time period to make any determination of investment skill. Investors get excited or depressed about specific companies at various times. The emotional state of the market is not a reflection of the actual value of a company. That actual value will generally be reflected over time periods much longer than a month, a quarter, or a year. Ignore short term performance and focus on longer time periods. A three to five year time period is a better gauge. A track record over several market cycles is best.
What has led to our success over the first five years?
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The Small-Cap Investing Handbook Part One: Introduction

This is the first part of what will be a ten part series on small-cap investing.

Throughout this series, I’m going to take a look 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.


small-cap investing
small-cap investing

The Small-Cap Investing Handbook Part One: Introduction

Small-capp stocks have a reputation that’s not necessarily good but at the same time, it is not necessarily bad. The majority of the world’s most renowned investors started their early careers by investing in small caps.

The reason why is because the likelihood of the market mispricing securities in the small-cap arena is much higher than with blue chips. Blue-chip stocks tend to be well covered by Wall Street analysts and owned by the largest funds. Small caps, on the other hand, are generally overlooked by Wall Street as it’s not lucrative enough to produce coverage on smaller names.

As a result, some small caps fly completely under the radar of most investors, and it’s here where the largest mispricings exist.

Small-cap investing – Building wealth

Warren Buffett is perhaps the most famous example (barring his tutor Benjamin Graham) of an investor who has used small caps to make a name for himself. In his early days, Warren Buffett made millions for his investors by investing in such names as Dempster Mill and Sanborn Map. Both of these examples were trading at a deep discount to net asset value when Buffett became involved because Wall Street had no idea of how much they were worth. Warren Buffett took the time to do the legwork and was richly rewarded as a result.

Peter Lynch is another investor who made a name for himself in the small-cap arena. Lynch is considered to be one of the greatest money managers of all time and he achieved this accolade by finding small-cap companies that weren’t yet on institutional investors’ radar.

Lynch firmly believed that individual investors had inherent advantages over large institutions because the large firms either wouldn’t or couldn’t invest in smaller cap companies that have yet to receive big attention from analysts or mutual funds.

Still, while Buffett and Lynch have made names for themselves by investing in small caps, investors should be under no illusion that small-cap investing is easy.

It is considered (although as you will see later not entirely factually correct) that because small caps can produce high returns than the market, investing in small caps comes with greater risk. Even though the evidence does not support this statement 100%, it is an important observation.

Unloved small caps can outperform because they fall under the radar of larger investors and research houses. However, because these small caps are not well researched, it is vital that you conduct your own rigorous due diligence. It’s here where most investors trip up.

The 25 Best Personal Finance Books To Read This Year

Both Warren Buffett and Peter Lynch are known for their researching ability. Buffett is known for his love of figures and continual study of company earnings reports, while Lynch was known for his hectic travel schedule to visit company managements when he was running the Fidelity Magellan Fund from 1977 to 1990.

Yes, small caps can outperform the market, but unfortunately, these premium returns don’t come easy.

Can small caps outperform?

The first study that seemed to suggest small caps can outperform appeared in 1980. Titled “The Relationship Between Return And Market Value Of Common Stocks” the study found that smaller firms have higher risk-adjusted returns, on average, than larger enterprises and this ‘size effect’ has been in existence for at least 40 years.

To arrive at this result, the relatively simplistic study broke companies down into market capitalization deciles and found that companies in the lowest decile and the higher returns, after adjusting for conventional risk. Figures showed that the average excess return from holding very small firms long and very large firm short is, on average, 1.52% per month or 19.8% on an annualized basis.

By replicating the above study and extending the sample period through to the end of 2014, Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University found that this small-cap performance anomaly has continued with companies falling into the lowest decile during the period 1926 to 2014 earning 4.33% more than the market after adjusting for risk.

The 1980 small-cap study has been used again and again as the basis for other academic studies on the topic and by actively managed small-cap funds in marketing materials. But today, there’s a growing debate over whether or not the small-cap premium actually continues to exist or if it has been arbitraged away by those seeking to profit from this market anomaly.

Stanphyl Capital March Letter To Investors

February letter from Stanphyl Capital. The hedge fund was profiled in our second edition and returned 31% in 2016. Check out the post and especially the end of the PDF for more on their small cap stocks.

For March 2017 the fund was down approximately 4.9% net of all fees and expenses. By way of comparison, the S&P 500 was up approximately 0.1% and the Russell 2000 was also up approximately 0.1%. Year to date the fund is down approximately 5.1% net while the S&P 500 is up approximately 6.1% and the Russell 2000 is up approximately 2.5%. Since inception on June 1, 2011 the fund is up approximately 116.5% net while the S&P 500 is up approximately 99.0% and the Russell 2000 is up approximately 77.4%. (The S&P and Russell performances are based on their “Total Returns” indices which include reinvested dividends.) As always, investors will receive the fund’s exact performance figures from its outside administrator within a week or two.

Our shorts really hurt us this month while our longs (collectively) had little impact. Despite this month’s awful performance, for the reasons outlined below I think there’s now much more money to be made on the short side of these markets than on the long side, and thus we remain net short. Here are the specifics…

In March I added substantially to our short position in the Vanguard Total International Bond ETF (ticker: BNDX), comprised of dollar-hedged non-US investment grade debt (over 80% government) with a ridiculously low “SEC yield” of 0.78% at an average duration of 7.7 years. As I’ve written since putting on this position in July 2016, I believe this ETF is a great way to short what may be the biggest asset bubble in history, considering that Europe and Japan (which comprise most of its holdings) are printing approximately $124 billion a month (¥6.7 trillion + €60 billion [tapered beginning in April from €80 billion]), yet are long-term insolvent due to their massive liabilities. What will force the bond buying to stop (beyond the April taper)? For Europe I suspect it will be intense pressure from Germany in the face of U.S. tariff threats due to the weak euro or perhaps pressure from German savers, or it could simply be inflation. And when European printing stops (or even tapers), I think asset prices of all types worldwide (including, or perhaps especially, stocks) will correct heavily. (See our Russell 2000 short, below.)

Japan I think can never stop printing (its ratio of debt to GDP is too huge and growing too quickly) but will eventually crash the yen into oblivion (we’ve been short yen since 2012) and with that its bonds will crash too. (I discuss Japan more extensively in the last paragraph of this letter.) The borrow cost for BNDX is less than 2% a year (plus the yield) and as I see around 5% potential downside to this position (vs. our basis,n plus the cost of carry) vs. at least 30% (unlevered) upside, I think it’s a terrific place to sit and wait for the inevitable denouement.

In March I also added substantially to our short position in the Russell 2000 (via the IWM ETF). I think this is a good hedge for our microcap long positions as well as an outright bet against what I perceive to be a dangerously expensive market, especially in the face of soaring auto loan defaults and a plunge in used vehicle prices that may be both a warning and a cause of a recession. Meanwhile, valuation is far above historical norms, measured by both a current PE of 138 and an EV-to-EBITDA ratio near 18x:

Stanphyl Capital
Stanphyl Capital

Again, I strongly believe that as Europe tapers its printing the liquidity that’s been keeping the equity bubble inflated will dry up and the bubble will burst. I can think of few better ways to profit from that than to be short this obscenely overpriced index.

Stanphyl Capital Letter continues below – skip to end to see small cap discussion

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