Sunday, April 01, 2007

Large Cap-Small Cap- All Cap???

In today's New York Times there is an interesting article on the topic of investment style. Mark Hulbert, founder of the Hulbert Financial Digest, the terrific monitoring service of newsletter recommendations, wrote the article. Hulbert does a great public service in examining the investing record of newsletters, most of under-perform the market over time.

He quotes a new article by Fama and French which appears here.

Fama and French are known for their conclusions in a 1992 Journal of Finance study which examined the capital asset pricing model, CAPM. Their main result is that two easily measured variables, size and book to-market equity (BE/ME), the inverse of price to book value, seem to describe the cross-section of average stock returns. Based on this finding, they conclude that beta is insufficient in explaining average return. In more direct terms, beta really had very little to do in explaining returns on stocks. Much better explanations were provided by market cap (smaller stocks outperform larger) and price to book (the lower the price to book relationship, the higher the likely return on a stock.) This was viewed as a particularly revolutionary paper by some academics because it represented a formerly very strong proponent of CAPM (Eugene Fama) relinquishing that belief and adopting a more fundamental view. Fama and French later wrote a paper on "Value versus Growth, the International Evidence" which demonstrated that value stocks( as defined by price/book) had outperformed growth in 12 of 13 markets for twenty years and that the average returns between high and low price to book stocks was 7.68% a year!

In the most recent paper, Fama and French study migration, that is value stocks that earn high returns and migrate to neutral or growth portfolios; growth stocks that earn low returns and move down to neutral or value portfolios; and finally, slightly higher returns earned on value stocks that do not migrate compared to growth stocks that do not migrate.

A few conclusions: The higher average returns of small stocks are due primarily to one type of migration: small stocks that become big – specifically, price appreciation moves a stock’s market cap from below to above the NYSE median from one year to the next. Big stocks that become small have strong negative average excess returns, but they contribute little to the size premium. This perhaps surprising result arises because, unlike stocks that move from small to big, stocks that become small account for tiny fractions of the market cap of big stock portfolios. the size premium in average returns for 1927-2006 traces almost entirely to the high average excess returns (more than 50%) earned by the 8-12% of small stock market cap that moves to a big portfolio from one year to the next.

In contrast, differences in transition frequencies for value and growth stocks largely drive the contributions of Plus and Minus migration to value premiums. Without changing size groups, there is little room for growth stocks to improve in type or for value stocks to deteriorate. Thus, Plus transitions are common for value stocks, but they are rare for growth stocks, and Minus transitions are common for growth stocks, but they are rare for value stocks. As a result, Plus transitions, which are accompanied by high returns, contribute about 3.5% (3.5 percentage points) more per year to the excess returns of small and big value portfolios than they do to the matching growth portfolios. Similarly, Minus transitions and their low returns are a bigger drag on the excess returns of growth portfolios.

There is more migration from small to big than vice versa. There is more competition for companies earning high returns, therefore over time, their returns and their size diminish. Small stocks disappear in mergers much more often than large stocks.

The migration effects are very important. Over the last 80 years, small cap value stocks returned a spectacular 22.5% versus 13.3% for the overall market. But had the stocks which shifted to the growth camp the following year not been kept in the value classification, the small cap value index would have actually under-performed the average stock with an annualized gain of only 13.1%. Bottom-line...great performance from small cap value stocks occurs because they become larger cap growth companies.

Think about this the next time you look at a Morningstar box for your mutual fund, or read an investment strategist who is encouraging you to now emphasize value versus growth or large cap versus small cap.

The stock doesn't know what box it lives in. Ideally, the management of that company doesn't know where it is classified either. All they should care about is creating value for the shareholders. Ultimately, the performance of the stock depends on the performance of the business. Your return depends on what you paid for the stock initially. Whether growth stocks are soaring or otherwise, the inherent growth attributable to your company is far more important than the characteristics of its peers. High returns attract competition. Returns falter, expectations shrivel, and your growth stock may fail to grow. These conclusions are almost biblical, "But many that are first shall be last; and the last shall be first."

The consultants who descend upon portfolios now that another quarter has passed love to pigeon hole investment managers into a box. I hate it. It is a stupid waste of time in my view. As Buffett so wisely stated, "Growth and value investing are joined at the hip." Growth investing sees value in finding companies that have strong growth characteristics that the market may not fully appreciate yet. Value investors seek companies that trade for less than intrinsic value.

One of life's great experiences is watching a single digit midget grow into a significant business. This, thank goodness, has occurred a few times in my career. It didn't happen because I was looking for a small cap value nor because I was looking for a growth stock. It happened because I was free to roam, because I was independent. Most of all, it happened because I was looking for a good business, not a stock that fit a classification.

Professional investors report not only to their clients but they toe a line created by the consultants. As I have said numerous times, every really good decision I have made in my career almost resulted in my being fired because of doing something controversial. Exercising freedom, exercising independent judgment is so very important. Unfortunately, consultants frequently do get in the way of decent portfolio managers. For me, the consultants came, qvetched and left. The clients who understood, stayed. As individual investors, I encourage you to use that freedom, the only one you have to satisfy is yourself. Don't own a large cap growth portfolio because you "need that exposure." Find a great business that you like and that has winning characteristics.Don't own a small cap value portfolio because you think it's going to "move." Own some great small cap company that has the wherewithal to be a great business. Think all-cap, but mostly, just think!


At 10:52 PM, Blogger Jim said...

Where did you find your statistics that the during the past 80 years, small cap value stocks returned 22.5% and the overall market returned 13.3%? I have seen various charts and articles about the outperformance of small cap value stocks over time, but I have never seen anyone mention an average annual return of even close to 22% per year. I have read that the returns of U.S. small cap value stocks since 1926 is around 15.9% annually. I also have never seen anyone mention a stock market average annual return of 13.3% per year over the past 80 years - I've seen articles mentioning a return of around 10-11% for U.S. large stocks since the mid-1920s.

At 1:54 PM, Blogger Rick said...

Hi Jim

Both of the links in this post highlight the return of 22.5% for small cap. Mark Hulbert in the NY Times article as well as the Fama and French article that Hulbert paraphrases.

Thank you for your comment!


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