Small Cap Equities — Inefficient & Opportune
(Part 1 of 2)

Categories Author: Chris Meredith, Author: Ehren Stanhope, Investing, U.S., Value

Small cap equities1 are generally misunderstood and underappreciated. We believe they present a phenomenal total return opportunity for discerning long-term investors. The construction of common small cap indices and the nuances of the small cap universe favor an active approach. The space has more stocks to choose from but significantly less analyst coverage and lower institutional ownership than larger capitalization ranges. The companies tend to be young and nimble with high growth potential. However, among small cap stocks there is a high degree of variability in quality, valuation, and liquidity that passive index investments mask over. This post details the disciplined process and research — accrued over two decades of managing small cap stocks — that we believe can provide small cap investors with consistent long-term total return.

Lack of Coverage & Ownership Drives Inefficiency

There are currently about three times as many stocks in the small cap space as there are in the large cap space, and ten times the number of mega cap companies. The size of the selection universe presents a significant dilemma for fundamental managers and sell-side analysts. Most fundamental managers — who pride themselves on qualitative analysis of individual companies and management teams — do not have the ability to cover the full breadth of the small cap universe. This is the same scenario for sell-side analysts. The amount of attention the investment community can give to any individual stock is limited. Therefore, focus is shifted toward the largest, most liquid names. As we will demonstrate, the largest, most liquid names tend to be poor performers.

The Inefficiency of the Small Cap Space (As of 12/31/2013)
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While mega cap stocks have 27 analyst earnings estimates on average, small cap stocks have just six. The small cap average of six is actually skewed high — 40% of the stocks in the small cap space have three or fewer analysts and nearly 20% have no analyst coverage at all. Similarly, institutional ownership in small cap tends to be very low. Issues with liquidity and the ability to make investments in size tend to push institutions away from small cap names. The implication is that this lack of coverage and institutional ownership creates significant inefficiency in the space.

Inefficiency Redefined = “An Opportunity for Excess Return”

This greater opportunity for total return, born out of inefficiency, can be shown by pretending as though we had perfect foresight. We ranked all small cap stocks based on their future return over the following 12 months. The stocks were organized into five buckets (quintiles) from highest to lowest performance. Keep in mind this group of stocks is similar to the Russell 2000® Index, which has generated an annualized return of 11.5% since 1964. The highest quintile of stocks outperformed by 65.2% per year for more than 5 decades. On the flip side of the equation, stocks in the lowest quintile underperformed by 50.8% during the same time period. The wide dispersion suggests there are significant benefits to aligning portfolios with the characteristics of consistent outperformers, while entirely avoiding companies with the characteristics of consistent underperformers. Our research leads us to believe valuation, quality, and momentum are themes that aid us to accomplish these tasks.

Excess Return Distribution of Small Cap Stocks (1/1/1964–5/31/2015)
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Single-Factor Approaches to Valuation are not “Smart”

Value investing works. However, a key consideration is determining what constitutes an undervalued investment. One approach is to allocate to a style index like the Russell 2000® Value. This index tilts stock weights based on price-to-book, earnings growth estimates, and historical sales growth (with price-to-book being the dominant factor). The simple application of this tilt allowed the Russell 2000® Value Index to outperform the Russell 2000® Index by 2.2% on average back to 1964 with an annualized return of 13.7%. The key differentiator for style indices is the application of selection criteria, which is absent in market-cap-weighted indices. But they are still suboptimal because traditional style indices rely on a weak valuation factor (price-to-book) and those indices own companies with poor characteristics, just in lower quantities than market-cap-weighted benchmarks.

We believe that defining valuation via a single factor is inferior for two reasons. First, just as value and growth styles move in and out of favor, so do individual factors. We evaluate the robustness of factors by testing for consistency over time All factor portfolios cited in this attribution report are calculated using a compositing methodology. Monthly portfolios are created with a 12-month holding period based on a single characteristic within a universe of stocks. The 12 monthly portfolios are then combined together to create the composite portfolio. using “base rates” (base rates are batting averages for how often factors outperform the market in rolling periods). Three-year base rates are particularly instructive as that tends to be about the length of time investors are willing to tolerate underperformance. On this measure, price-to-book does not perform well. Investing in the cheapest stocks by price-to-book has merely a 58% 3-year batting average versus small cap stocks, underperforming in an unimpressive 42% of 3-year periods. The chart below is a visual representation of the batting average, showing rolling 3-year excess returns of the cheapest decile of price-to-book. There are long periods of time where underperformance tends to be clustered. For 146 months (12.2 years) from 1930–1942, the cheapest stocks by price-to-book posted negative excess return over the trailing 3-year period, with one exception in January 1938. This happened again from 1955–1963 when the cheapest decile of price-to-book posted 96 consecutive months of negative 3-year excess return.

Rolling 3-Year Excess Performance: Cheapest Decile Price-to-Book vs. Small Cap Stocks2
(1929–2013)
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The second reason single factors are inferior to multi-factor composites is that all factors have biases to sectors, cap ranges, and liquidity buckets, which can result in real world implementation issues. Liquidity is a particularly important consideration in the small cap space. If a factor concentrates investments into illiquid stocks, excess return suggested in backtested results may not be realizable in investor portfolios. We define illiquid stocks as those having average dollar volume of less than $250,000 per day, adjusted for inflation. A simple $5 million trade in the least liquid quintile of the small cap market can cost upwards of 2.8% in terms of market impact — per each trade! Liquidity is critically important in real world implementation.

We have found this to be the case with price-to-book. Stocks in the cheapest decile by this factor tend to skew to illiquid names. Currently, the cheapest decile of stocks by price-to-book has a 35-percent allocation to the least liquid names in small cap. It turns out these illiquid names generate the bulk of excess return (+6.3%) associated with the factor. The most liquid stocks within the cheapest decile actually underperform by 2.3% historically. This is particularly important when thinking about a style benchmark like the Russell 2000® Value Index — 43% of the index falls into the most liquid quintile, where price-to-book is least effective.

Liquidity Analysis: Highest Decile of Price-to-Book and the Russell 2000® Value Index
(1/1/1974–5/31/2015)
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Unbeknownst to most index investors, they are effectively exchanging excess return for greater liquidity and product capacity.

A Multi-Factor Approach is Strong

We believe in the assessment of valuation based on a combination of multiple factors — sales, cash flows, earnings, and return of capital to shareholders — that we refer to as our Value composite. A multi-factor approach provides strong total return, risk-adjusted return, and overall consistency versus numerous single factors that we have tested, including price-to-book.

In the chart below, we divide small cap stocks into deciles based on a Value composite score. The least expensive stocks are in the first decile while the most expensive are in the tenth decile. Not only do the most expensive small cap stocks underperform by an astounding 11.2% per year from 1964–2014, but they do so 85% of the time in rolling 3-year periods. Invest in these expensive stocks at your own peril. On the other end of the spectrum, the cheapest decile outperforms by 6.3% on average while outperforming in 89% of all rolling 3-year periods.

Annualized Excess Returns: OSAM’s Multi-Factor Value composite3 vs. Small Cap Universe
(1964–2014)
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Diversification and the interactive effects of a multi-factor approach provide more robust results at both ends of the spectrum while also eliminating the aforementioned issue of factor timing. The equal-weighted Value composite outperforms its underlying constituents 83% of the time in rolling 10-year periods.

Additionally, multi-factor models tend to mitigate the biases inherent in single factors. Continuing the liquidity analysis, our Value composite is more evenly distributed across liquidity buckets. Unlike price-to-book, the Value composite generates significant and positive excess return in even the most liquid small cap names, which suggests its ability to outperform is not as reliant on illiquidity premiums and the excess returns suggested by researched results are more likely to be realized in a capacity-constrained space.

Liquidity Analysis: Cheapest Decile of OSAM Value4
(1/1/1974–5/31/2015)
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Go to Part 2

  1. In this post, we will refer to small cap stocks for all research. This universe includes all stocks trading on the NYSE, AMEX, and NASDAQ with an historical inflation-adjusted market capitalization between $200 million and $2 billion.
  2. Source: CRSP, mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html, OSAM calculations
  3. ”OSAM Value” equal-weighted factors: Price-to-Sales, EBITDA-to-Enterprise Value, Price-to-Earnings, Free Cash Flow-to-Enterprise Value, Shareholder Yield
  4. ”OSAM Value” equal-weighted factors: Price-to-Sales, EBITDA-to-Enterprise Value, Price-to-Earnings, Free Cash Flow-to-Enterprise Value, Shareholder Yield