Small Cap Stocks Outperform Other Asset Classes and Value Beats Growth

Over a long investment horizon, small cap stocks deliver superb investment returns, better than any other asset class and many percentage points better than the market as a whole. Once we have reviewed the evidence, you can read the articles and screens we publish regularly that aim to find new small cap stock ideas for our readers. We can also send you all these ideas and screens in your email as they are published so you never miss them.

There is a body of research that shows that over a long investment horizon, small cap stocks have outperformed their large cap brethren. At the same time, value stocks outperform growth. In one study, Ibbotson Associates studied the annual performance of stocks classified by size (large, mid, small and micro) as well as by style (growth and value) between the periods 1969 and 2002. They found that the small cap value and micro cap value stocks far outperform all other asset classes. At the same time, small cap growth and micro cap growth are the worse performing asset class (as many who chase ipo stocks will attest).

	Geometric	Arithmetic	Standard	Sharpe
	Mean (%)	Mean (%)	Deviation (%)	Ratio
All Growth	8.79	10.72	20.25	0.21
All Value	10.99	12.31	17.08	0.34
Large-Cap Growth	8.9	10.91	20.75	0.21
Large-Cap Value	10.43	11.75	17	0.31
Mid-Cap Growth	8.88	11.09	21.88	0.21
Mid-Cap Value	13.03	14.66	19.37	0.42
Small-Cap Growth	8.2	11.04	24.77	0.18
Small-Cap Value	14.35	16.41	21.69	0.46
Micro-Cap Growth	6.47	10.2	28.66	0.13
Micro-Cap Value	14.66	17.44	24.69	0.44

 

See also: share book value
Another interesting insight from this table is that for every capitalization class, the value stocks have smaller standard deviation from the mean, which implies that value stocks carry less risk than their growth counterparts with similar sized companies.

Looking at the Sharpe Ratio, which measures risk adjusted returns, it is striking to see the difference between the highest performing asset class (Small-Cap Value) and the lowest performing asset class (Micro-Cap Growth). Small Cap Value stocks have historically returned highest returns for any level of risk you are willing to take in your investments.

What is beta of a stock?

Another study that measured asset class performance between 1927 and 2005 confirms a similar pattern.

	Value	Growth
Large Cap	9.21%	6.17%
Small Cap	12.13%	5.77%
Total Stock Market	6.72%

 

Still, investors continue to focus on finding the next explosive growth story. For every Microsoft or Cisco Systems, there are literally hundreds of growth stocks that fizzle out. Odds of finding that one stock that will secure your retirement is slim, perhaps even less than the odds most casinos give you.

Why do Small Cap Value Stocks Perform So Much Better?

If you follow the Efficient Market Hypotheses, you would assume that if the markets are efficient, than any source of out-performance will be quickly eliminated as investors discover these stocks and pile on. However, there are very practical reasons why this does not happen in the real world.

1. Small Cap Value stocks are generally very boring companies that no one has heard of. These are unglamorous companies, unlikely to garner much oohs and ahhs around the dinner table
2. Investors over react to growth prospects and bid up the shares high. That is why growth stocks are expensive and provide smaller returns. On the flip side, investors over react and force the smaller value stocks down at the slightest whiff of bad news or general discomfort.
3. There is insufficient coverage of these stocks on the Wall Street due to smaller size and lack of liquidity. As a result, they escape the attention of most institutional and retail investors who depend on stock brokers or sell side analyst’s recommendations
4. Most institutions and funds are not allowed to own small and micro cap stocks and if they do come into possession of any such stock, perhaps due to a spin off, they are forced to sell off their position
5. Many small stocks fall into special situations and become difficult to analyze using traditional fundamental analysis processes

Due to these reasons, there is little investor interest in small stocks. But enterprising value investors know that small caps offer the best places to find true value stocks that will on average comfortably beat the market over the long term.

Are Small Cap Stocks Riskier?

For most investors that do not have enough time or skill to commit to screening for and researching small cap stocks, these stocks are indeed riskier. The risk though comes from the lack of information - this is not necessarily due to any inherent risk embedded in small company stocks. If you are willing and able to put in the time and effort to seek the information on the companies you are investigating, the risk is no longer acute.

I would argue that if you are able to conduct sufficient due diligence, small company stocks can actually be less risky. Here are a few reasons why:

1. Small companies have simpler business models and are easier to understand and model
2. Small companies have more approachable management to help answer your questions
3. Small companies have less analyst following, making it less likely that these companies are beholden to quarterly earnings management for the benefit of the wall street

Finding Promising Small Cap Value Stocks

Russell 2000 index tracks the 2000 small cap stocks in the US. You could invest in this  index through one of the funds that track this index. Alternatively, you can use this as a source list and review the stocks that make up this index. Look for the best small companies that look promising enough to consider a buy. You may want to look at analyst rating for each company and perhaps read the financial reports and any research papers these services put out. It is very likely that you will run into a paucity of such reports as analyst coverage for these stocks tend to be sparse.

Once you have a short list of best small cap companies, you will need to research each of these stocks to see if they meet your valuation criteria. Each company should  be researched further. A typical small company will have very little by the way of analyst coverage, so the research involved poring through the financial statements, reading up on any press reports, and even communicating with the management to ask questions where necessary. Due to liquidity issues in small caps, you ought to be ready to  hold any of the stocks you buy for a long time. Frequent trading is not advisable. You may be tying up significant capital in each issue but a good application of value investing  process will ensure  a speedy growth in your wealth.

With the coverage of these stocks so scant, a value investor literally needs to comb through the entire universe of small cap stocks to find promising candidates. With each of these stocks, the investor needs to go through the public filings and annual reports to understand the company, analyze the business and its financials and figure out a reasonable valuation of the company. Once this research in small cap stocks is complete, it is a matter of purchasing those stocks that offer good value and patiently wait for the market to understand its folly and discover these stocks. This is time and labor intensive work for most investors and a typical investor is not willing to patiently sit on his or her shares for a long time if immediate returns are not visible. However, patience is required if you want the rewards. That is why we help investors find great value stocks to buy through our Premium service.

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