The Investment Scientist

Posts Tagged ‘small cap value

ImageIf you are a typical investor, given the choice between investing in a small cap value fund or a large cap growth fund, which one would you choose?

You would probably go with the large cap growth since “large cap” sounds a lot safer than “small cap,” and “growth” sounds a lot more promising than “value.”

To prove how wrong you are, I did a study of the relative performances of these two styles in the eight decades between 1931 and 2010. Here is what I found.

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Last year, while the S&P 500 was largely flat, small cap value and emerging markets were down significantly. No wonder some clients of mine got a bit edgy.

What a change one month has made! As of Feb. 5, these two asset classes have roared back with a vengeance. See the table below.

2012 Year to Feb 5th 2011
DFA US Small Cap Value 12.74% -9.74%
DFA Emerging Mkts Value 19.44% -26.50%
DFA Intl Small Cap Value 12.74% -19.41%

The lesson here: when we see big losses like -19%, -26%, we can view them as a financial Armageddon or as a buying opportunity. The latter position is mentally much harder to take, but it almost always pays off. 

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MZ Capital 70/30 model vs S&P 500

(Performance stats last updated on 8/16/2011) I have maintained 4 model portfolios since the beginning of 2007 to show that successful investing can be extremely simple: one only needs to do 1)prudent allocation, 2)disciplined rebalancing. One does not need Harry Dent’s prescience nor Jim Cramer’s encyclopedic knowledge to be successful in investing.

This report shows the construct and performance of the 70/30 model portfolio, the most aggressive of the four. The chart on the right shows the portfolio value of $100 invested on the first day of 2007, relative to the S&P 500.

Asset Classes and Fund Selection

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If you invested $1 in the small cap value index at the beginning of 1927, you would have had $52,892 by the end of 2010. This is according to the recently published Dimensional Fund Advisors’ annual Matrix Book. Included in the book are historical risk and returns of various indices based on capitalization and book-to-market valuation.

Table 1 presents a summary of historical returns. The best returns are marked in green; the worst, marked in red. As one can see, the small cap value index is the best for all the periods considered. And it is the best by a huge margin.

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Recession Stock Market

Three years ago, at the onset of the recession, I performed research analyzing the previous nine recessions after WWII and wrote an article “Recession and Stock Market Performance” based on that research.

Given that I am not clairvoyant – unlike many market pundits and some fellow financial advisors – I can’t see the future. I can only use my research of the past to frame my perspective of the future.

I came away with two conclusions:

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MZ Capital 40/60 model vs S&P 500

Just like two sides of a coin, the capital market is made up of capital demanders (businesses) and capital suppliers (investors). What for businesses are costs of acquiring capital are for investors rewards of supplying it. It is a simple truth that

Costs of Capital = Expected Returns

Looking through this lens, many capital market phenomena can be explained.

Why small stocks tend to have higher returns than large stocks?

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Look beyond comfort zoneIf you are like most investors, your equity portfolio will have a few auspiciously named stock funds and a few company stocks you feel comfortable with. You think you are well-diversified, but you really are only investing in the universe of the S&P 500 – the largest 500 stocks of the US equity market.

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The recession is very likely over.” – Fed Chairman Bernanke on 9/15/09.

What does the fed chairman’s statement mean for stocks, if indeed the worst recession since 1929 is over? We don’t know for sure. We can, however, let history be our guide.

In this spirit, I studied the one-year and three-year returns of the S&P 500 Index and the Fama/French Small Cap Value Index coming out of a recession for the nine recessions since 1950.

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In January 2008, I wrote in my article “Recession and stock market performance” that:

Small cap value stocks are likely to outperform.

With one week left in 2008, the Russell 2000 Value Index, representing small-cap value stocks, has lost 34%. This is bad, but not as bad as the S&P 500 Index’s 41% loss and the Nasdaq 100’s 43% loss this year. The S&P 500 Index represents the largest 500 stocks in the U.S. and the Nasdaq 100 represents the largest 100 growth stocks.

Since January, I’ve heard pundits recommending large-cap stocks, tech stocks, pharmaceutical stocks, etc. Never once have I heard them recommend small-cap value stocks, which they claim are the most vulnerable in a recession.

Do I have a better crystal ball?

No, I don’t. I simply know the odds. As I wrote in “Small-cap value underperforming: a historical perspective,” the odds that small-cap stocks will outperform large-cap growth stocks on aggregate in any given year is 75%. So I can make the same “prediction” year after year and still be right about 75% of the time.

Why do most investors shun small-cap value?

According to Daniel Kahneman, father of behavioral economics, certain types of information are more accessible than others to the human mind. For instance, the concept of probability is not intuitively accessible, but descriptive words like “small,” “large,” “value” and “growth” leave instant impressions on our minds.

Another discovery of Kahneman is that humans take mental shortcuts in decision making. Confronted with the choice between large-cap growth and small-cap value, most investors eschew the hard route of calculating odds. Instead, they rely on their intuition that “large” is safer than “small” and “growth” has more potential than “value.” Thus, they “decide” to shun small-cap value stocks.

Small-cap value premium

An undesirable job has to pay more to attract job-seekers. Likewise, a shunned asset class commands a higher expected return in equilibrium. As long as small-cap value is not an intuitively attractive asset class, this return premium will continue.

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July 2008 marks the start of a bear market after all major market indices have fallen more than 20% from their most recently peaks. This article is part two of my three-part research on bear markets. In part one, I researched how long a typical bear market lasts?. In this installment I ask this question:

Which style fared the best in a one-year time frame after stocks have entered a bear market?

There are four primary styles of stock investing: Small Cap Value (SV), Small Cap Growth (SG), Large Cap Value (LV), and Large Cap Growth (LG). Typically, before stocks enter into a bear market, Small Cap stocks, regardless of value or growth, get hit the hardest.

Using data provided by Fama/French benchmark style portfolios, I calculated one-year returns of the four investment styles from the month stocks entered a bear market. The results are tabulated below.

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Confusing volatility and risk could cost you a bundle. Let’s take a look at returns on an investment of $1000 over 50 years from 1958-2007 in five asset classes.

  • Small cap value: $3,750,000
  • Small cap growth: $81,200
  • Large cap value: $854,000
  • Large cap growth: $130,000
  • CD: $13,800

Isn’t it obvious which is the best long-term investment?

Why small cap value is the best long-term investment

So you don’t have a 50-year investment horizon? Few of us do. How about a ten-year horizon? In any ten-year period from 1958 to 2007, small cap value had much better investment results than a “safe” CD. (See Table below. Green = best result in the given ten years; red = worst.)

Table: How would $1 investment become?

    10 year periods Small Cap Growth Small Cap Value Large Cap Growth Large Cap Value CD
    1958-1967 $5.64 $8.02 $3.22 $5.39 $1.36
    1968-1977 $0.97 $2.66 $1.2 $2.64 $1.75
    1978-1987 $3.38 $7.84 $3.52 $4.96 $2.41
    1988-1997 $2.87 $6.47 $5.38 $5.13 $1.7
    1998-2007 $1.53 $3.47 $1.77 $2.36 $1.42
    Annual volatility 28.23% 24.05% 17.67% 18.54% 1.7%

Safety paradox

Even though a FDIC guaranteed CD is perceived to be safe, over time, inflation eats away at returns. For the long-term investor – and by that we mean you – small cap value is less risky.

Why do few investors put their long-term investment in small cap value? And, when the going gets rough, why do many small-cap-value investors switch their money to CDs?

Here’s why, small cap value is highly volatile (See last row of Table) and volatility makes us anxious and jumbles our judgments.

Volatility does not measure risk.” -Warren Buffet

Volatility becomes risk only when the investor can’t stand it anymore, and abandons an otherwise safe long-term investment. Typically, volatility is highest and its impact most painful when the market reaches bottom. Not surprisingly, many investors bail out at the worst possible time.

Upon learning that he had to sail by the Sirens – the creatures whose beautiful songs could lure him to jump to his death – Odysseus asked his sailors to tie him to a mast. What mast do you tie yourself to?

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Author

Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.

Twitter: @mzhuang

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