Do you believe in the small cap value phenomenon?

[wildcat]

Simple question. I have read a lot of articles/books. Some well-respected people believe it in and some don't. What do you think? If you do believe in small cap value phenomenon, do you think it will continue in the future? Could it be that the past 6-8 years worth of returns persuaded you?

I am getting busier with work and I am probably going to just dump everything into a set asset allocation. I am kind of questioning whether or not I want to split the small cap area - i.e. I don't know if I believe in te extra returns from smallc cap value. At times, I just think it would be easier to hold the VG Extended Index rather than the splitting anything.

 

[LOL!]

I guess my answer has to be yes because the last two things I bought were DLS and VBR. But what do I know?

 

[brewer12345]

Yes, I do.

 

[FinanceDude]

Yes, I do.

As do I, and the portfolio manager I am working with now.........

I think the key word is VALUE........

 

[kcowan]

There si also some validity to small cap growth. Traditional measures sometimes do not work because earnings are sacrificed for growth. But it is volatile and very dependent on the sentiments of people like us because big players like pension funds are limited in their participation.

 

[justin]

yes 567890

 

[cardude]

Small caps are just like any other asset class.........they can get expensive and they can get cheap. So I wouldn't say there is an overall "phenomonem", although I do think you can sometimes find small caps to buy at a deeper discount than large caps due to the lack of press most small caps get.

Currently I would say small caps as an overall asset class are expensive while large caps are relatively cheaper, but it's still dangerous to think one class will outperform another forever.

 

[cardude]

Small caps are just like any other asset class.........they can get expensive and they can get cheap. So I wouldn't say there is an overall "phenomonem", although I do think you can sometimes find small caps to buy at a deeper discount than large caps due to the lack of press most small caps get.

Currently I would say small caps as an overall asset class are expensive while large caps are relatively cheaper, but it's still dangerous to think one class will outperform another forever.

According to Leuthold's research, small-caps have sold at a discount to large-caps about 54 percent of the time since 1983. Yet, currently, small-caps are selling at about an 11 percent premium. Floyd said the median small-cap stock would have to decline 28 percent to return to a median valuation. "In a nasty bear market," Floyd said, small- and mid-cap stocks "could be expected to fall about 49 percent."

 

[genghis]

You didn't say what the so called "phenomenon" is.

 

[Olav23]

My logical reasoning would be that you are getting a larger payout (and higher volatility) due to a perceived and measurable (in aggregate) extra amount of risk you are taking. The often quoted 9-in-10 small businesses fail leads me to believe that you need to be paid extra for taking this risk of business failure. The 9-in-10 go to zero, but the ones that make it become winning lottery tickets as they graduate to mid-caps and then large-caps


Whether you can actually capitalize on the premium is another question, though.

 

[FinanceDude]

My logical reasoning would be that you are getting a larger payout (and higher volatility) due to a perceived and measurable (in aggregate) extra amount of risk you are taking. The often quoted 9-in-10 small businesses fail leads me to believe that you need to be paid extra for taking this risk of business failure. The 9-in-10 go to zero, but the ones that make it become winning lottery tickets as they graduate to mid-caps and then large-caps


Whether you can actually capitalize on the premium is another question, though.

True, at some point in time, EVERY stock was a small cap, even Microsoft and GE............

 

[genghis]

My logical reasoning would be that you are getting a larger payout (and higher volatility) due to a perceived and measurable (in aggregate) extra amount of risk you are taking. The often quoted 9-in-10 small businesses fail leads me to believe that you need to be paid extra for taking this risk of business failure. The 9-in-10 go to zero, but the ones that make it become winning lottery tickets as they graduate to mid-caps and then large-caps


Whether you can actually capitalize on the premium is another question, though.

So the "phenomenon" is that accepting higher risk leads to greater return? Then yes, I believe in that phenomenon.

 

[FinanceDude]

So the "phenomenon" is that accepting higher risk leads to greater return? Then yes, I believe in that phenomenon.

 

[maddythebeagle]

True, at some point in time, EVERY stock was a small cap, even Microsoft and GE............

yeah, and some large caps turn back into small caps

 

[wildcat]

Small caps are just like any other asset class.........they can get expensive and they can get cheap. So I wouldn't say there is an overall "phenomonem", although I do think you can sometimes find small caps to buy at a deeper discount than large caps due to the lack of press most small caps get.

Currently I would say small caps as an overall asset class are expensive while large caps are relatively cheaper, but it's still dangerous to think one class will outperform another forever.

Talking more along the lines of small cap value, not small caps in general.

Whether you can actually capitalize on the premium is another question, though

I suppose that is my thought. Given the huge swings in small cap value, will I be invested long enough to see a return that justifies the allocation. And will small cap value index funds allow one to capture the return.

Up until recently I used to think mid caps weren't worth holding but now in some ways I think it could be the sweet spot of the market's returns.

 

[pedorrero]

My current guru is O'Shaughnessy. In his latest (2006) book "Predicting the Markets of Tomorrow", I think his favorites are large-cap value and small-cap (er...) growth? He does make the good case that one sector often has its run, to be overtaken by another. I believe the current wisdom (his, at least) is that small caps have had their run and its time for ... well read the book! Right now, I do one of his micro-cap screens called "Tiny Titans" which is a combo of value (low P/S) and growth (relative strength). Trade annually, low commissions, volatile (very), huge potential return. Even he doesn't recommend it for more than a fraxion of your portfolio.

-- Pedorrero, changing the spelling of the language at his leisure.

 

[Olav23]

Right now, I do one of his micro-cap screens called "Tiny Titans" which is a combo of value (low P/S) and growth (relative strength).

When you say growth, do you mean growth prospects or growth of the stock price? Relative strength is usually a momentum trading signal.

Digging up my random walk down wall street book, Malkiel is very vocal on a lot of systems that try to beat the market. Here is what he has to say:

Does Value really trump growth on a consistent basis-

(paraphrasing)

We must remember that results of published studies, even those done over decades may still be time dependent. ... Value funds are characterized if they buy stocks with a low P/E and low P/BV ratios. We see that over the period running back to the 1930, it does not appear that investors actually have realized higher rates of return from mutual funds specializing in value stocks. Indeed, the chart suggests that the period studied by French/Fama from the early 60s through 1990 may have been a unique period in which value stocks rather consistently produced higher rates of return.

Schwer points out that investment firm of DFA actually began a mutual fund that selected value stocks quantitatively according to Fama/french methodology. The excess risk adjusted return was a negative 0.2% per month over much of the 90s (using beta as measure of risk). To be fair, it should be noted that value funds did very well during the first 6 years of the 2000s.

 

[wildcat]

Olav -

Good paraphrase. That pretty much sums up my skepticism. That was what I was trying to get out of people ----- not whether or not you could earn higher returns by investing in small cap stocks.

 

[mb]

OK, I think we need some clarification from the finance guys here because if my understanding is correct we are not really addressing the question properly.

This is my understanding:

- The EMH suggests that only way to obtain obtain greater return is to assume greater risk
- If that is the case then return should be a unique, montonically increasing function of beta (volatility) and beta should be the only statistically significant independent variable
- But the problem is that is not the case
- If you do the statistics it turns out both market cap and style are statistically significant and that greater returns are obtained for value (vs growth) and small cap (vs large cap)
- These returns are in excess of what one would expect from risk alone
- This is the justification for the so-called 3 Factor model that explains market return in term of risk, market cap and style

I think that is the question, do value and small cap yield excess growth that cannot be explained by risk? If it does then it makes sense to slant your AA in that direction because you get greater return without assuming greater risk if not then the only way to increase return is to increase risk and you should just increase your equities exposure if you want greater return.

I have heard the argument that excess value return is a result of the "lottery effect" where everyone is looking for the next Microsoft and thus bid up the price of growth.

I don't recall who discovered the market cap and value effects? French and Fama?

I haven't read anything about the research being flawed so I have to assume that it did work in the past.

Will it work going forward? Don't have a clue!

MB

 

[mb]

I haven't read anything about the research being flawed so I have to assume that it did work in the past.
MB

Base on Olav's post it sounds like Burton is questioning the research.

MB

 

[Olav23]

We could go back and forth about this, I think, but nothing actionable will come of it. It is sorta like dogma, you either believe or you don't. In the end, your portfolio will tell the tale!

I'll leave this with two more paper from fama/french:

SSRN-The Value Premium and the CAPM by Eugene Fama, Kenneth French

[FONT=ARIAL, HELVETICA] We examine (i) how value premiums vary with firm size, (ii) whether the CAPM explains value premiums, and (iii) whether in general average returns compensate beta in the way predicted by the CAPM. Loughran's (1997) evidence for a weak value premium among large firms is special to 1963-1995, U.S. stocks, and the book-to-market value-growth indicator. Ang and Chen's (2003) evidence that the CAPM can explain U.S. value premiums is special to 1926-1963. The CAPM's general problem is that variation in unrelated to size and value-growth goes unrewarded throughout 1926-2004. This produces rejections of the model for 1926-1963 and 1963-2004.[/FONT]

and:
SSRN-The Anatomy of Value and Growth Stock Returns by Eugene Fama, Kenneth French

[FONT=ARIAL, HELVETICA] We break average returns on value and growth portfolios into dividends and three sources of capital gain, (i) reinvestment of earnings, (ii) convergence in price-to-book ratios (P/B) due to mean reversion in profitability and expected returns, and (iii) upward drift in P/B during 1926-2003. The capital gains of value stocks trace mostly to convergence: P/B rises as some value firms become more profitable and move to lower expected return groups. In contrast, reinvestment, which is trivial to negative for value portfolios, dominates the capital gains of growth stocks. For growth stocks, convergence is negative: P/B falls because growth stocks do not always remain highly profitable with low expected returns.[/FONT]

 

[samclem]

There's good eveidence that, over time, small cap and value stocks have eturned more than other stocks on a risk-adjusted basis. Obviously, that doesn't mean that these stocks will outperform every year, or even every decade. My portfolio is tilted toward these equities (using low cost Vangaurd index funds, mostly). I also believe more strongly in the value premium than the small stock premium.

Value stocks/MFs have two traits I like:
-- When irrational exuberance takes off, it is growth stocks (not value stocks) that bubble and burst. If a value stock catches the eye of speculators, it will soon be bid up to the point that it isn't a value stock anymore, and my MF will sell it. That's good for me.
-- Their dividend returns are higher than growth stocks. Returns from dividends are more stable than growth in stock prices, so this helps reduce annual variation in my returns.

But, with a portfolio like this, some years I won't match the S&P 500 index. And I sure won't have great stories to pass along at parties about stocks that have gone through the roof.

 

[cute fuzzy bunny]

Growth does have its day, but there arent many of them. Many more years of value trumping growth than the other way around.

I guess one way to look at it is that being a top notch growth company is pretty tough to sustain. Being a semi bad company or company with endemic problems with a beaten down stock price and a nice dividend, on the other hand, seems to be something sustainable for decades.

Somewhat more risk/reward in small companies with these 'problems' vs large companies. The large companies can have strategy/product/management/distribution problems for a lot longer before they hit the ground.

And as pointed out, every once in a while one of those sad little companies figures it out and becomes a good big company.

At which point you should sell.

Bernstein may have said it most succinctly when he said that bad stocks are good to own and good stocks are bad to own.

Half my IRA is in small cap value index, other half is in a target retirement fund...all dividends/gains from both go into the small cap value fund.

 

[W2R]

There's good eveidence that, over time, small cap and value stocks have eturned more than other stocks on a risk-adjusted basis. Obviously, that doesn't mean that these stocks will outperform every year, or even every decade. My portfolio is tilted toward these equities (using low cost Vangaurd index funds, mostly). I also believe more strongly in the value premium than the small stock premium.

That is my opinion as well. It's hard to be enthusiastic about my small cap funds, but I do have them. The small cap tilt in my portfolio is not very marked. The value tilt is substantial.

I am about as far from an investment guru as you could find, though, so it would probably be stupid to be influenced by what I do. Instead, I would suggest Bernstein, Swedloe, and an AA that you feel comfortable maintaining for a long time.

 

[cute fuzzy bunny]

Who Killed Value?

Nice little read, with PICTURES! for those of us who are word impaired.

Interesting sidebar is noting the positive effect value stocks have during times of high inflation, reflecting back to our 'discussion' that wellesley (holding primarily value stocks in its equity portion) wasnt considered a decent inflation hedge.