Small Cap Investing

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One of the most widely used passive growth strategies is the strategy of investing in small companies, with small defined in terms of market capitalization. While you could construct a value oriented, small cap portfolio, most small cap portfolios tend to be tilted towards growth companies, and we believe that this category fits better in this chapter. We will begin by reviewing the empirical evidence on small cap investing, and then look at the requirements for success at this strategy.

The Small Cap Effect

Studies have consistently found that smaller firms (in terms of market value of equity) earn higher returns than larger firms of equivalent risk, where risk is defined in terms of the market beta. Figure 9.1 summarizes annual returns for stocks in ten market value classes, for the period from 1927 to 2001.1 The portfolios were reconstructed at the end of each year, based upon the market values of stock at that point in time, and held for the subsequent year.

1 These annual returns were obtained from the annual returns data set maintained by Ken French and Gene Fama on market value classes.

Figure 9.1: Annual Returns by Market Value Class - 1927 - 2001

Figure 9.1: Annual Returns by Market Value Class - 1927 - 2001

p Value Weighted □ Equally Weighted

Source: Raw data from French

If we look at value weighted portfolios, the smallest stocks earned an annual return of about 20% over the period as contrasted with the largest stocks which earned an annual return of 11.74%. If we use an equally weighted portfolio, the small firm premium is much larger, an indication that the premium is being earned by the smallest stocks. In other words, to capture the small cap premium, you would have to invest in the very smallest companies in the market. Nevertheless, these results are impressive and provide a rationale for the number of portfolio managers who focus on buying small cap stocks. Before we conclude that small cap investing is the way to go, though, we do have to consider some of the details of the small stock premium.

Small Cap Cycles

On average, have small cap stocks outperformed large cap stocks over this period? Absolutely, but, success from this strategy is by no means guaranteed in every time period. While small cap stocks have done better than large cap stocks in more periods than not, there have been extended periods where small cap stocks have underperformed large cap stocks. Figure 9.2 graphs the premium earned by small cap stocks over large cap stocks from 1927 to 2001.

Figure 9.2: Small Firm Premium over time- 1927 -2001

Figure 9.2: Small Firm Premium over time- 1927 -2001

Source: Raw data from French

Note that the premium is negative in a significant number of years - small stocks earned lower returns than large stocks in those years. In fact, during the 1980s, large market cap stocks outperformed small cap stocks by a significant amount, creating a debate about whether this was a long term shift in the small stock premium or just a temporary dip. On the one side, Jeremy Siegel notes that the small stock premium can be almost entirely attributed to the performance of small stocks in the late 1970s. Since this was a decade with high inflation, could the small stock premium have something to do with inflation? On the other side are small cap portfolio managers, arguing that the events of the 1980s were an aberration and that the small stock premium would return. On cue, the small stock premium returned in the 1990s, as can be seen in figure 9.3 below:

Small Cap Effect over Time

Small Cap Effect over Time

1973-1994

1982-1990

1990-1994

1995-1999

1973-1994

1982-1990

1990-1994

1995-1999

Source: Pradhuman (1998) Pradhuman takes a close look at the small cap premium in his book on the topic.2 He notes that small cap stocks tend to do much better than large cap stocks when the yield curve is downward sloping and inflation is high, which may explain why the premium was high in the 1970s. He also finds that the small cap premium tends to be larger when default spreads on corporate bonds narrow. In summary, there is a return premium for small cap stocks but it is a volatile one. While the premium clearly exists over long time periods, it also disappears over extended periods.

Deconstructing the Small Cap Effect

A number of studies have tried to take a closer look at the small cap effect to see where the premium comes from. The following are some of the conclusions:

• The small cap effect is greatest in the micro-cap companies, i.e., the really small companies). In fact, many of these companies have market capitalizations of $250 million or lower. All too often these are also companies that have low priced and illiquid stocks, not followed by equity research analysts.

2 The book titled "Small Cap Dynamics" is one of the most detailed looks at the phenomenon.

• A significant proportion of the small cap premium is earned in January. Figure 9.4 presents the contrast between small cap and large cap companies in January and for the rest of the year between 1935 and 1986:

Figure 9.4: The Small Firm Effect in January

Figure 9.4: The Small Firm Effect in January

Source: Raw data from French

In fact, you cannot reject the hypothesis that there is no small cap premium from February to December. Many of the other temporal anomalies that we noted in chapter 7 such as the weekend effect also seem to be greater for small cap companies.

• There is evidence of a small firm premium in markets outside the United States. Studies find small cap premiums of about 7% from 1955 to 1984 in the United Kingdom,3 8.8% in France and a much smaller size effect in Germany4 and a premium of 5.1% for Japanese stocks between 1971 and 1988.5

Explanations for the Small Stock Premium

The persistence of the small stock premium has led many to argue that what looks like a premium in empirical studies comes the failure to allow for transactions costs and

3 See Dimson and Marsh,

4 Updated numbers are reported by Fama and French.

5 Chan, Hamao and Lakonishok measure risk correctly in firms. There is truth in these arguments, though it is unclear whether the small stock premium would disappear even if they were considered.

Transactions Costs

The transactions costs of investing in small stocks are significantly higher than the transactions cots of investing in larger stocks, and the premiums are estimated prior to these costs. In chapter 5, for instance, we looked at the bid-ask spread as a percent of the stock price and noted that it tended to be higher for smaller companies. In addition the price impact from trading is also higher for small cap stocks because they are less liquid. Can the difference in transactions costs overwhelm the small cap premium? The answer has to depend upon your time horizon. With short time horizons, the transactions costs can wipe out any perceived excess returns associated with small cap companies, With longer time horizons, though, you can spread the costs over your holding period and the excess returns may persist.

In a telling illustration of the difficulties associated with replicating the small firm premiums that are observed in the studies in real time, we compare the returns on a hypothetical small firm portfolio (CRSP Small Stocks) with the actual returns on a small firm mutual fund (DFA Small Stock Fund), which passively invests in the same small stocks in figure 9.5:

Figure 9.5: Returns on CRSP Small Stocks versus DFA Small Stock Fund

Figure 9.5: Returns on CRSP Small Stocks versus DFA Small Stock Fund

DFA Small Firm Fund CRSP Small

Note that the returns on the DFA fund consistently lag the returns on the hypothetical portfolio by about 2%, reflecting the transactions and execution costs faced by the fund.

Failure to consider liquidity and estimation risk

Many of the studies that uncover a small cap premium measure the risk of stocks using a market beta and the capital asset pricing model. It is entirely possible that the capital asset pricing model is not the right model for risk, and betas under estimate the true risk of small stocks. Thus, the small firm premium may really reflect the failure of the market beta to capture risk. The additional risk associated with small stocks may come from several sources. First, the estimation risk associated with estimates of beta for small firms is much greater than the estimation risk associated with beta estimates for larger firms, partly because of the fact that small companies tend to change more over time and partly because of their short histories. The small firm premium may be a reward for this additional estimation risk.6 Second, there may be much greater liquidity risk associated with investing in small companies. This risk (which is also partially responsible for the higher transactions costs noted in the previous section) is not captured in betas.

While the argument that liquidity and estimation risk can be significant problems for small cap stocks seems unexceptional, there is one problem with it. Note that portfolios of small cap stocks do not carry the same risk as individual stocks and that estimation risk, in particular, should be diversifiable. Estimation risk will lead you to under estimate the risk (or betas) of some small companies and over estimate the risk (or betas) of other small companies. The beta of a portfolio of such companies should still be predictable, because the estimation errors should average out. With illiquidity, the diversification argument is tougher to make, since it manifests itself as a higher cost (bid-ask spread or price impact) for all small stocks. Thus, the illiquidity risk will show up as higher transactions costs in a small-cap portfolio and will increase as trading in the portfolio increases.

Information Risk

When investing in publicly traded companies, we tend to rely not only on the financial reports filed by the company but also on the opinions of analysts following the company. We expect these analysts, rightly or wrongly, to collect information about the firm and reveal this information in their reports. With a large and widely held firm, it is not uncommon to see 25 or 30 analysts following the firm and substantial external information on the firm. Many small cap firms are followed by one or two analysts and many are not followed by any, as you can see in figure 9.6.

6 The problem with this argument is that it does not allow for the fact that estimation risk cuts both ways - some betas will be underestimated and some will be overestimated - and should be diversifiable.

Analyst Coverage

Analyst Coverage

Large Cap

Mid Cap

Micro-cap covered by analysts -Average number of analysts

Large Cap

Mid Cap

Micro-cap

With some small-cap firms, you may find that the only source of information is the firm itself. While the firm may follow all of the regulatory requirements, the information revealed is unlikely to be unbiased, and it is entirely possible that bad news about the firm's operations may be withheld. Since you cannot diversify away this risk, you may demand a premium when investing in these companies.

Determinants of Success at Small-cap Investing

Let us concede, notwithstanding the period in the 1980s where the premium waned, that small cap stocks earn a premium over large cap stocks, when we adjust for risk using conventional measures like beta. Given the discussion in the last section about potential explanations for this premium, what do you need to do to succeed at small cap investing?

• The first and most critical factor seems to be a long time horizon, given the ups and downs of small cap premium. In figure 9.7, we examine the percent of time a small cap investor would have outstripped a large cap investor with different time horizons. Note that the number is close to 50% for time horizons up to five years, no different from a random strategy. Beyond 5 years though, small cap investing wins decisively.

Figure 9.7: Time Horizon and the Small Firm Premium

120.00%

5 10 15 20 25 30 Time Horizon

Large Cap Small Cap

% of time small caps win

A long time horizon will also go a long way towards reducing the bite taken out of returns by transactions costs.

• The importance of discipline and diversification become even greater, if you are a small cap investor. Since small cap stocks tend to be concentrated in a few sectors, you will need a much larger portfolio to be diversified with small cap stocks.7 In addition, diversification should also reduce the impact of estimation risk and some information risk.

• When investing in small cap stocks, the responsibility for due diligence will often fall on your shoulders as an investor, since there are often no analysts following the company. You may have to go beyond the financial statements and scour other sources (local newspapers, the firm's customers and competitors) to find relevant information about the company.

If you combine the need for more stocks in your portfolio with additional research on each, you can see that small cap investing is likely to be more time and resource intensive than most other investment strategies. If you are willing to expend these

7 The conventional rule of thumb for being diversified (where you diversify away 95% of the firm-specific risk) with large cap stocks is about 25 stocks. With small cap stocks, you would need to hold more stocks. How many more? It will depend upon your strategy, but you should consider holding at least 40-50 stocks.

resources and have a long time horizon, you may well be able to claim a large portion of the small cap stock premium going forward.

Small Cap Value Investing

While we have considered small cap investing as a strand of growth investing, you can be a small-cap value investor, if you focus on small companies that trade low PE or low PBV ratios - the conventional measures of value companies. Investors who do this hope to combine the excess returns that have been uncovered for buying stocks that trade at low multiples of earnings and book value with the excess returns associated with small cap investing.

Pradhuman, in his book on small cap investing, contrasts a strategy of buying small cap value stocks with small cap growth stocks and presents several results. First, the excess return on a small cap, value strategy is less than the sum of the excess return on a value strategy and the excess return on a small cap strategy. In other words, there is some leakage in returns from both strategies when you combine them. Second, the difference in returns between value and growth small-cap stocks mirrors the difference in returns between value and growth large-cap stocks, but the cycles are exaggerated. In other words, when value stocks outperform (underperform) growth stocks across the market, small-cap value stocks outperform (underperform) small-cap growth stocks by an even larger magnitude. Third, the excess returns in the last two decades on a small-cap, value strategy seem to be more driven by the value component than by the small-cap component. 8

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