Small-Cap Value Investing – the USA Experience

There are literary tens of thousands of stocks traded in major regulated exchanges worldwide.  The million-dollar question for the would-be investor is what stocks derive the highest returns?  To arrive at an answer, we’ve to come out with a working functional investment strategy.  There’re many types of good investing strategy, small-cap value investing is one such turbo-charged investment tactics.

Small-cap investing refers to the investment in small-capitalization stocks while value investing refers to the investment in low price/book, price/earnings, price/cash flow, price/sales and high dividend yield stocks.  The consensus for small-cap value investing arises due to the historical higher returns of SCV investing.  Some finance academics argue that the higher returns are because SCV stocks are riskier and that risks and returns are correlated, i.e. they are a risk story while others debate that it’s more of a behavioral issue, i.e. their high returns are a free lunch and investors should grab them while they’re there.

Personally, I feel that small-cap investing is riskier thus resulting in their higher returns.  Small-cap stocks tend to have more volatile stocks price fluctuations.  The companies tend to operate in small niche markets with undiversified product lines.  Some of the products they sell might even be untested in the mass market!  However, because of their smaller size, they’ve more legroom to grow and expand.  This is unlike large companies where their products are already matured and highly penetrated in the markets, thus limiting their future growth.

On the other hand, I feel that the value premium is more of a free lunch.  While growth stocks tend to grow faster (somewhat in the near future) and are stars of the stock markets with a bright future, there’s no reason why companies with stronger fundamentals (value stocks) should have a premium in returns.  The matter of the fact is that value stocks are being under-valued in terms of prices (above and beyond what’s fair) and investors are handsomely rewarded by loading up with them instead of growth stocks.

Regardless of the reasons for their high profits, the excess returns have been spectacular historically and it’s persistent over different countries and long-term periods.

In this article, I shall focus my discussion on SCV investing in the USA market due to the availability of long-term and clean data and because of the size of the market itself.  I derive my points from the data gleaned from the Kenneth French data library which is freely download-able over the Internet at http://mba.tuck.dartmouth.edu/pages/faculty/ken.french/data_library.html.  My source of stock prices will be based on the file “6 Portfolios Form on Size and Book-to-Market (2×3)” as the constituent stocks inside the portfolios are widely diversified and reasonably comparable to SCV ETFs/mutual funds/Unit Trusts on the market.  The portfolios are divided into large-caps and smalls caps and then into growth, blend and value style.

The portfolios are very long-term in nature, they backdate from 1926 till now (84 and a half years).  That’s about as long range a set of clean data as you can get.  It’s important to backtest the strategy with long-term data as we can remove doubts as to whether the SCV strategy is period specific.

First the cumulative returns (1927-2011).

Style SCG SCB SCV LCG LCB LCV
Annualized returns 8.7% 13.1% 14.7% 9.2% 9.9% 11.5%

I use large-cap blend as the benchmark as it’s the most frequently quoted in the news and media.  As you can see from the table, small-cap blend beats large-cap blend by 3.2% and large-cap value beats large-cap blend by 1.6%.  This validates that style investing in value and small-cap stocks has its merits.  Small-cap value beats large-cap blend by a whopping 4.8% annualized.

To put things into perspective, if a 25 year-old youngster were to invest $10,000 in small-cap value stocks and do nothing else and then draw it 40 years later at a retirement age of 65; he would have accumulated $2.41 million!  This is a growth of 241 times!  The point is, very few investors in investing history has such a stellar performance.  This result best exemplified the benefits of long-term buy-and-hold and the power of SCV investing.

This chart shows the growth of 1 dollar from 1927 till 2011.

Note that the chart is a logarithmic chart.  Each unit in the vertical axis is 10 times the size of the unit below.  The stocks might trend in a straight line towards the top, but in actual fact, they are growing exponentially in nominal terms.

If we take investing periods of 5 years as the short term, 10 years as the mid-term and 20 years or longer as the long term, we can further examine the efficacy of SCV over shorter term periods than provided in the data library file.

If we subdivide the French’s data library historical prices into 20 year periods, we’ve 4 distinct sub periods.

Style SCG SCB SCV LCG LCB LCV
1932-1951 17.2% 18.1% 21.1% 10.6% 13.2% 16.2%
1952-1971 11.5% 14.3% 16.1% 11.4% 10.9% 14.4%
1972-1991 9.2% 15.7% 17.6% 10.6% 12.9% 15.5%
1992-2011 5.1% 13.0% 14.6% 7.9% 9.4% 8.6%

From the table, all periods and styles have positive returns and the returns are all strongly positive.  SCB beats LCB 4 times out of 4.  LCV beats LCB 3 times out of 4.  SCV beats LCB 4 times out of 4.  SCV is the top performer for all 4 periods.  The premiums of SCV stocks range from 4.7% to 7.9%.  Please note the compounded significance of even 4.7% (the lowest) over a single 20-year period.

Next, we look at 10 year periods.  We have 8 distinct sub periods.

Style SCG SCB SCV LCG LCB LCV
1932-1941 15.8%

15.1%

13.3%

7.1%

8.4%

8.3%

1942-1951 18.6%

21.1%

29.5%

14.3%

18.1%

24.6%

1952-1961 14.8%

16.8%

16.4%

15.5%

16.4%

17.3%

1962-1971 8.3%

11.7%

15.8%

7.4%

5.6%

11.5%

1972-1981 9.1%

13.9%

17.2%

4.1%

10.0%

12.8%

1982-1991 9.3%

17.5%

18.1%

17.5%

15.9%

18.3%

1992-2001 6.5%

17.3%

20.4%

12.3%

15.2%

15.1%

2002-2011 3.7%

8.8%

9.2%

3.6%

4.0%

2.4%

Based on the table, all periods and styles also have positive returns.  SCB beats LCB 8 out of 8 times.  LCV beats LCB 5 out of 8 times.  SCV beats LCB 7 out of 8 times.  SCV is the top performer in 5 periods while LCV is top in 2 periods.  The premiums of SCV over LCB range from 0.0% to 11.3%

How about 5 year periods?  We will have a look at it next.

Style SCG SCB SCV LCG LCB LCV
1927-1931

-18.6%

-15.5%

-20.3%

-4.3%

-14.5%

-17.4%

1932-1936

44.7%

44.1%

46.5%

21.6%

25.5%

29.1%

1937-1941

-7.4%

-8.1%

-12.4%

-5.8%

-6.3%

-9.1%

1942-1946

28.0%

32.1%

44.3%

14.4%

21.2%

30.4%

1947-1951

9.9%

11.1%

16.1%

14.3%

15.1%

19.1%

1952-1956

13.8%

17.9%

17.0%

18.5%

17.8%

21.6%

1957-1961

15.9%

15.8%

15.8%

12.5%

15.0%

13.2%

1962-1966

3.4%

7.6%

14.0%

4.9%

6.3%

10.8%

1967-1971

13.5%

15.9%

17.6%

10.0%

4.9%

12.1%

1972-1976

-3.6%

4.5%

10.1%

1.1%

9.2%

14.4%

1977-1981

23.4%

24.2%

24.7%

7.3%

10.7%

11.3%

1982-1986

10.4%

23.4%

27.9%

16.1%

20.0%

24.6%

1987-1991

8.2%

11.8%

9.0%

18.9%

11.9%

12.2%

1992-1996

8.8%

18.3%

23.3%

13.2%

17.7%

17.5%

1997-2001

4.2%

16.3%

17.5%

11.3%

12.7%

12.8%

2002-2006

5.6%

16.3%

19.7%

4.0%

10.4%

9.8%

2007-2011

1.8%

1.8%

-0.4%

3.3%

-2.0%

-4.5%

Here, stock investing is no longer a sure thing.  There are periods where stock investing got slaughtered no matter what style you adopt.  Even SCV stocks have 3 periods where there are negative returns.  Also, SCV stocks lose out to LCB 4 out of a possible 17 times.  The premiums of SCV stocks over LCB ranges from -6.1% to 23.2%.  As you can see, the range of SCV premiums is quite wild/unpredictable over the shorter term.

The lesson learned from historical evidence is that stock investing is viable only for the long term.  Over the shorter term, results are kind of erratic with negative returns for some periods.  If your funds are short term in nature with needs to draw on them for housing, retirement or education, do not invest in the stock market.  You would definitely not want to dabble in the stock market only to discover later that you’re at the beginning of a major bear market.

Also, for the long term, although SCV stocks have the highest returns, stock investing is viable no matter which style you adopt to. Even SCG stocks, which has the lowest returns of them all, is strongly positive.  The most important determinant for success is that you can buy-and-hold through the ups-and-downs periods.  The results are all positive in nominal terms, what style you adopt only affects how much you make subsequently.

The conclusion of this exercise is that it’s definitely possible to tilt a well-diversified portfolio to small-cap value stocks to increase returns.  Historically, SCV investing has served us well.  While it’s not a sure thing that the SCV premium will persist in the future, it’s a better bet to assume that it will.

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