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

10 May

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

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