Small Caps – Investiv

Historically, small cap value stocks are the best performers.
They don’t trade in sync with the market and often are waiting to be discovered.
The “waiting to be discovered” period can last for a few years.

Introduction

Almost a month ago we discussed how, from a risk-reward perspective given current valuations and historic performance, it isn’t a smart idea to invest in small cap growth stocks at the moment. Today we are going to discuss small cap value stocks to see if they will fare better on our long-term risk-reward scale.

Small Cap Value

In order to be categorized as a small cap value stock, a company has to have a market capitalization below $2.5 billion and its stock price has to trade below its book value (where possible, or have the lowest book value).

There are several benefits to having a small market capitalization. One is that a company is then always a takeover target and as we discussed last week, that can bring about instant returns when an acquisition is announced. Other benefits include growth prospects as it is easier to grow when you are smaller. For stock pickers like us, it is always a benefit when a company is a small cap because it is less frequently, or even not, followed by analysts, and thorough due diligence pays off as sooner or later the market recognizes good companies even amongst small caps.

On the value side, when a company is trading below its book value it means that the risks of investing are limited because in the case of a business liquidation or bankruptcy, there are enough assets to cover all stakeholders. However, proper due diligence here is essential as there is a big difference between having lots of fixed assets on your balance sheet and having lots of goodwill. In difficult times, goodwill is impaired as the acquisition that created it was obviously a mistake while fixed assets like real estate are of real value on the balance sheet. Researching beyond the balance sheet can bring further benefits as by understanding the story behind a property, plant and equipment account, one can discover that some buildings are completely depreciated and not even on the balance sheet. Such a situation with no analysts following a company is a real gem, but it takes a lot of research of diligently going through every single small cap in the stocks universe.

Small Cap Value – Historical Performance

For those investors who don’t have the time to research small caps in detail, diversified investing into small cap value stocks has been the best thing to do over the past 40 years. Investing into U.S. small cap value stocks would have outperformed all other investment options.

Figure 1: Investing by size and value – performance since 1979. Source: Author’s calculations.

$100 invested into small cap value stocks at the end of 1979 would have returned $11,027 today, while investing in mid cap value stocks would have returned $9,605 in the same time frame, in the S&P 500, $5,199, and in small cap growth stocks only $3,216.

This outperformance is nothing new. Back in 1992, Fama and French developed their famous three factor model—which earned them the Nobel prize (French, unfortunately passed away and was not formally awarded a Nobel)—where they found that value and size give the highest premiums to stock returns. Twenty-four years later, the story should be the same. The iShares S&P Small-Cap 600 Value ETF (IJS) has had an average return 9.48% since its inception in 2000, thus no matter when the measuring started, this strategy outperforms other strategies.

The current PE ratio of the iShares S&P Small-Cap 600 Value ETF is 19.21 which is the same as the iShares Core S&P 500 ETF (IVV), but the difference lies in the price-to-book value which is 1.64 with small cap value stocks, 2.88 with the S&P 500 and 2.92 with the small cap growth ETF. From a fundamental perspective, this is where the difference lies.

Why Do Small Cap Value Stocks Outperform?

The are many answers to this question. To find them, you have to dig in the dirt and not many analysts are willing to do that as it is easier to follow the crowd with big names. Big investment funds have to wait for a company to reach a large market capitalization to invest in it, but by then the major profits have already been accounted for. If you are an investment manager and you make a mistake by overpaying for a large cap, there will be no hard feelings as everybody else did so as well, but if you recommend a small cap and the story doesn’t end well, you will probably be fired.

The last reason is that value lowers investing risk. If the business doesn’t end well, there are always assets to sell to cover the losses. Therefore, small cap value stocks trade at a premium which ultimately delivers higher returns.

What’s The Catch?

Investing in small cap value stocks comes with a catch that many investors don’t have the stomach for. The catch is that small cap value stocks tend to have a mind of their own and don’t move in sync with the S&P 500. For example, in 2015 the S&P 500 returned 1.3% while small cap value stocks had a return of -6.84%. The same was true in 2014 when the S&P 500 was up 14% while small cap value stocks were only up 6.5%. In 2007, the S&P 500 was up 5% while small cap value stocks lost 8%. How would you feel if when talking to your neighbor, they are up more than 20% in the last two years while you have a negative return?

The thing is that small cap value stocks have to first be discovered by the masses, and only then, when they become trendy, do they boom by getting a fair market valuation. Therefore, an investor may wait for a long time and underperform—like in 2014 and 2015—but sooner or later things change. Year-to-date, small cap value stocks are trendy again and are up 13.6% compared to the S&P 500’s 6.5%.

Conclusion

Investing in small cap value stocks is not for everybody but it delivers the best returns in the long term. The low liquidity, higher uncertainty and general unwillingness to research small caps means a higher premium which in the end, brings about higher returns. Investors who are ready to invest in small cap values will be rewarded in the long term.

In an environment like we’re in now with lots of monetary stimulus, value might be the way to go as assets increase in value in inflationary times. We don’t see inflation yet, but it is bound to happen sooner or later. Growth stocks with high debt levels will be the first ones to suffer when higher interest rates arrive, and historically are the worst performers. Therefore, look into your portfolio and if you don’t have small cap value stocks, be sure to include some.

On Friday we attempted to send you a report Sven had written but had some issues with the links. It just so happens the company featured in this report happens to be a small cap value stock in the metals and mining space that we believe has yet to be discovered by the market. To access this free report ($49 value) click here, and to access the most recent update on the featured company click here.

Many of you also may not have received yesterday’s Sunday Edition featuring a reprint from Thomas Moore’s Rebel Income newsletter. In yesterday’s issue, Thomas discussed why stock assignments aren’t a bad thing and how to take advantage of them. To access the Sunday Edition, click here.

Jul

Should You Bet On Small Cap Growth Stocks? Why It May Not Be A Good Option Now

By Sven Carlin - Investiv Daily, Market Forecast, Small Caps

Small cap growth stocks only outperform in the two years after market bottoms.
At this moment they provide more risk and less returns than the S&P 500.

Introduction

While it’s possible to make money in the stock market, it’s not easy. One thing an investor should know well, and constantly assess, is their exposure to various kinds of stocks, from value and growth stocks to large or small caps. Each type of stock performs differently depending on the economic cycle. However, over the long term small caps and value stocks have outperformed the rest of the market.

In this article we are going to investigate what we might expect from small cap growth stock performance at this moment in the economic cycle.

Small Cap Growth

Small cap growth stocks are companies whose earnings are expected to grow at an above average rate, relative to the market and their market capitalization, which is typically less than $2.5 billion. These companies have tremendous potential and if they manage to become large cap stocks, the returns to shareholders are phenomenal. This is magnified by the fact that mutual funds are often restricted in buying small caps and thus as a company grows there are more and more buyers who can invest.

While the returns of investing in small caps can be very rewarding, the risk is also higher than with large caps. Since the business isn’t as well established, there is a lack of corporate transparency, and more difficulty in attracting capital.

The chart below shows how small cap growth stocks have performed in various cycles since 1980 in comparison to the S&P 500.

Figure 1: $100 invested in the S&P 500 vs U.S. small cap growth stocks in 1980. Source: Fidelity, iShares, Author’s Calculations.

In the long term, the S&P 500 outperformed small cap growth stocks even with the standard deviation of returns being much lower (22.33 for small cap growth and 16.2 for the S&P 500). A higher standard deviation of returns means that you can expect more volatility, thus more risk, but as we can see it does not translate into higher returns over the long term. A higher standard deviation means that there will be periods when small cap growth stocks outperform.

In researching the performance of small cap growth stocks through economic peaks and troughs, the conclusion is that small cap growth stocks outperform other types of stocks in the short period after recessions. Investing $100 in small cap growth stocks at the beginning of 2009 would have returned $181 in the next two years and largely outperformed the S&P 500’s $144. However, from 2011 onwards the S&P 500 would have outperformed small caps by 10% in total.

The same situation happened after the 2003 bottom where small cap growth stocks returned $175 for a $100 investment in the two years after 2003 and outperformed the S&P 500 which returned only $142. The same holds for the 1991 recession with two year returns at $170 for small cap growth stocks and $139 for the S&P 500.

So one thing is pretty clear: small cap growth stocks outperform after the economy and the markets have reached their bottom. This is good to know for future recession lows, but does not help much in the current seven-year bull market.

By looking at the data from 1980, small cap growth stocks have underperformed in all the stable growth periods from two years after the bottom to the peak of the market. They also underperform in bear markets and flat markets.

Figure 2: Small cap growth performance in bad and stable years. Source: Fidelity, iShares, Author’s Calculations.

This means an investor would do well to avoid small cap growth stocks at all times except for the darkest recession and bear market periods.

Rationale

Given that long term returns are correlated to underlying earnings, the first thing to consider in order to better understand the performance of small cap growth stocks is valuations. The iShares S&P Small-Cap 600 Growth ETF (NYSEArca: IJT) has a PE ratio of 24.29 and a Price to Book ratio of 2.9, while the iShares Enhanced U.S. Large-Cap ETF (NYSEArca: IELG) has a PE ratio of 19.84 and a price to book ratio of 2.3. Higher valuations make small cap growth stocks riskier, and at the first sign of a recession or tightening of financial markets, investors flee small cap growth stocks, which is the reason for their underperformance in flat and bear market years.

The reason they outperform in the recovery phase of an economic cycle is derived from the above. Since small caps are battered in recessions, their recovery is much better as they start from a lower starting point and have to play catch-up. As soon as they catch up, they begin to underperform as their valuations are usually too high.

Figure 3: Stock types and economic cycles. Source: BlackRock.

Also, large caps are more globally diversified and derive about 38% of their revenues from abroad. Small cap growth stocks are mostly concentrated on their focus market and do not have the benefits of international diversification to help them in case of a U.S. recession.

What To Do

Passive investors should rethink their exposure to small cap growth stocks. As most, if not all of the extra returns from the 2009 recession low have been made, they now offer a lower return for more risk than a boring investment in the S&P 500.

However, there is one caveat. During moments of an economic peak like today, merger and acquisition activity intensifies, which should give a boost to small cap growth stocks. If you hold a portfolio consisting of many small cap growth stocks, you might want to select the ones that have a higher chance of being bought out by a bigger company.

May

Small Caps: Time to Invest?

By Sven Carlin - Investiv Daily, Small Caps

Small caps have lagged the S&P 500 in the last two years, but historically outperform it.
Stock pickers could find a gem in the small cap world but risks are also big.
Small caps are more related to the US economy than large caps.

What Are Small Caps?

Small caps are stocks with a relatively small market capitalization, usually between $300 million and $2 billion. One of the multitude of reasons behind investing in small caps is their growth potential, as it is generally considered that smaller companies have more growth opportunities due to untapped markets. Another reason for investing in small caps is the fact that big investment funds might overlook some smaller profitable investments due to their lack of liquidity or low free float. Thus, an astute investor can make large profits by buying the next large cap at low prices, before the big guys buy in and raise the price. As small caps are mostly local companies, or constrained to one country, they should not be affected by macroeconomic influences like slower Chinese growth or the strong dollar. A technical reason to invest in small caps is that they have underperformed the market in the last 5 years and now might be a good time to change the weighting of a portfolio from blue chips to small caps.

Historical Performance

The most popular index for tracking small cap returns is the Russel 2000 Index which comprises 2,000 small cap companies from the US. The Russel 2000 has returned 33.6% in the last 5 years and underperformed the S&P 500 which returned 52%.

Figure 1: Russel 2000 and S&P 500 5-year performance. Source: Bloomberg.

The underperformance was probably caused by increased turmoil in junk bond markets and financing difficulties while big companies continue to enjoy low interest rates.

But, underperformance could indicate an opposite effect in the future as both indices are well diversified and their performance should reflect the US economy. Also, analysts expect the Russel 2000 earnings to grow by 9.6% in 2016 and S&P 500 earnings to be flattish. From a fundamental perspective the PE ratio is on the S&P 500 side at 24.12 while the Russel 2000 has an incredible 401.25. Although, 2016 estimates are on Russel’s side, with 17.52 versus the S&P 500’s 17.65. The high current Russel 2000 PE ratio is probably related to the fact that many small US companies are in the US shale oil sector which has been battered in 2015 and continues to fall as many companies file for bankruptcy.

Risks of Investing in Small Caps

Small companies tend to be more uncertain than their bigger counterparts. There is no loyal customer base, operational history and every project immediately looks riskier. It is always easier for the big fish in the pond to weather storms, correct mistakes or grasp opportunities. Ownership is more concentrated and there is a lower trading volume and free float. A low free float makes a stock vulnerable to short attacks.

Small caps have limited access to capital and the current increases in interest rates create more future uncertainty. Limited access to capital makes small caps reluctant to pay dividends as available capital is steered towards growth investments. Information is also scarce, analysts may have limited access to financial statements prior to an IPO and future forecasts are based on less reliable information.

Figure 2: Number of analysts and coverage. Source: New York University.

But, the low coverage percentage and limited number of analysts creates opportunities.

Advantages of Investing

Low coverage might enable a stock picking investor to discover a gem and create returns that cover for all the risks. A small starting base makes growth easier and especially in a quickly evolving digital world, small caps have the ability to change strategy faster than large caps. Aside from stock picking, a small cap index fund can also bring good returns. Historically the longer the investing period the higher the small cap returns and the certainty of over performance are.

Figure 3: Time horizon and small firm premium. Source: New York University.

The average return for small caps from 1930 to 2013 was 12.7% while the S&P 500 index returned 9.7% and as the above research shows in any period longer than 20 years small caps have always outperformed the S&P 500 index.

US or International Small Caps

The small cap over performance holds its grounds also on a global level. Only in Norway, Denmark and Italy did small caps not earn a premium in relation to large caps in the long term.

Figure 4: Annual premium earned by small cap over large cap stocks. Source: New York University.

Investing Opportunities

The first investing strategy is to look for small caps that give quality diversification to a portfolio and allow it to hit the jack pot. This requires lots of an investor’s own due diligence as most of the small caps are poorly followed by analysts and they involve high risk.

The second potential investing strategy is to invest in small caps through index funds or ETFs. Besides the Russel 2000, the second most popular small cap index is the S&P Small Cap 600 index. As it does not include all small caps, it provides better sector diversification.

Figure 5: S&P 600 sector breakdown. Source: S&P Dow Jones Indices.

A fund tracking the S&P 600 index is the Vanguard S&P Small-Cap 600 Index. For global ETF small cap diversification, opportunities include the SPDR S&P International Small Cap ETF that invests only in non US developed countries. The Vanguard FTSE All-World Ex US Small Cap ETF (VSS) provides a mix of developed and emerging small caps, and there are also much riskier emerging countries ETFs like the Market Vectors Brazil Small Cap ETF (BRF).

Conclusion

Investing in small caps can bring increased returns but it also increases risks as the volatility is much higher than for large caps. In any case, small caps should be a part of a well-diversified portfolio. Increased diversification can be achieved by going global.

Category Archives: Small Caps

Small Cap Value Stocks Have The Best Returns, But Can You Stomach The Catch?

Should You Bet On Small Cap Growth Stocks? Why It May Not Be A Good Option Now

Small Caps: Time to Invest?