There’s a puzzle when it comes to investing in small companies.
There’s evidence saying private investors should build their portfolio around small caps. But not many investors take that advice. There’s a gap between academic evidence on one side, and private investors on the other.
What do I mean by “the evidence says they should”? Well, when economists first got their hands on computers, the first data sets they could find were stock prices. So they crunched the numbers. And one of the very first things they spotted was that small companies return a lot more than big companies. It seemed to be true over long periods and in many different markets.
They called it the small company effect.
The small company effect was first spotted in 1981, and it’s been confirmed in many studies since then. What it means is that if you sort stocks into different portfolios based on their size, the smaller portfolios tend to outperform.
How much do they outperform? Well, the effect is pretty big. One study showed the smallest firms outperform the biggest firms by 1.6% per month! Another shows 2.6% per month. Another shows 1.9% per month. 2.6% outperformance every single month adds up quite quickly.
Now, those numbers are calculated quite simply. They just show the difference in performance between the biggest stocks and smallest stocks. The numbers don’t take into account the fact that small companies are more risky – and risky assets tend to have bigger returns.
But, when you adjust for the extra riskiness of small companies, small stocks still outperform big ones. One famous study come up with a number for the risk adjusted returns of 0.74% every month.
It’s international too. It works in 17 of 18 countries. And in the UK, the Numis Smaller Companies index has beaten the FTSE All-share by 3.2 per cent a year since 1955.
Why doesn’t everyone do this?
So there’s a lot of evidence that small company shares outperform. Why doesn’t everybody do it?
The reason is this: despite all this evidence that small cap stocks outperform, making money from investing in small caps has not been straightforward. It’s not as simple as buying a portfolio of small cap shares and forgetting about them.
The “small company effect” is clear as day when you’re looking back at historical data. But it’s been hard to find it in the here and now.
That’s why the small company effect is more of a curiosity for academic finance types. And it’s why more people don’t know about it.
So that’s the background.
Today I want to talk about some new research which shows exactly why ordinary investors haven’t been able to make money from the small company effect. It shows where it went to, how to find it, and how to make money from it.
The right way to invest in small stocks
The research comes from economists at the University of Chicago and AQR Capital, which is one of the world’s biggest hedge funds. AQR’s founder and principal, Cliff Asness, is the lead author of the paper.
I’ll get straight to the good part: the paper says that if you exclude what it calls “junk” stocks, all the problems with the small company effect melt away. Excluding junk stocks gives you a simple, clear strategy for making money in small cap stocks.
You get a big premium over the market…
adjusted for risk…
proven over many decades…
that is not explained by liquidity factors…
that’s agnostic to growth vs value strategies…
a premium that gets bigger the smaller the company is.
How to cut out junk stocks
I’ve been saying that it’s all to do with something called “junk”. Junk is just another word for quality. The big insight of the paper is that if you buy “quality” stocks and leave out their opposite – junk stocks – you get a much better return from investing in small caps.
I’ll repeat that in a slightly different way – the paper shows that small companies return more than big companies, provided you omit junk stocks.
What’s the intuition here? Basically it turns out that the problems with investing in small caps can be blamed on the fact that many companies with a low market value are a scam, or on the verge of death. If you’ve been around Aim for a while you’ll recognise what I mean – companies with a nameplate in central London, zero profits and a fancy website.
Those sorts of companies’ market value are low because they are headed towards zero. If you exclude them, you get bigger returns in small stocks.
So how do you get rid of junk stocks?
To answer that question, Cliff Asness and his team made a very broad test for quality. They came up with four things investors should be willing to pay more for, all things being equal.
They were looking for companies that are profitable.
Profits are measured in several ways: including gross profits, margins, earnings, accruals and cash flows, and focus on each stock’s average rank across these metrics.
Companies that are growing. They measure growth as the prior five-year growth in each of our profitability measures.
Companies that are safer. Stocks that are less volatile, and with less debt.
Companies that pay out to shareholders. This means bigger dividends and less dilution by issuing new shares.
So that’s how Asness and his team did it – they controlled for stocks with high profitability, high growth, high safety and a high payout ratio.
The results speak for themselves: they’ve found that if you cut out junk stocks, you can boost returns by 0.7% every month. Removing junk more than doubles performance in the long run.
Read about it… or do it
As editor of The Penny Share Letter, I’ve been beating the drum about this. I want to put this idea to work for ordinary investors.
I’ve built my entire newsletter around the strategy. Using a professional-grade screening software, I screen for the same characteristics described in Asness and co’s research. Then I choose the most promising growth companies from the shortlist.
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