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The Small-Cap Investing Handbook Part Three: Size Matters

30 Apr

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.

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