Small Cap Equities — Inefficient & Opportune
(Part 2 of 2)
(Part 1 linked here)
Avoid Value Traps via a Quality Overlay
Not every cheap stock outperforms. Even within the cheapest decile of value, there is wide dispersion in underlying stock returns. Certain stocks are cheap for a reason: value traps. Small cap stocks exhibit worse quality characteristics on average than their large cap cousins, so quality characteristics play a crucial role in avoiding these traps. Far from esoteric minutiae, the quality characteristics we employ to avoid certain stocks are rooted in key management decision making about how to make use of shareholder capital, accounting policies, and profitability.
One of the key quality metrics concerns the financing of company operations. Raising capital is commonly viewed as a positive sign because it serves as an indication that a small firm has passed the litmus test of the capital markets. Our research suggests this is a false assumption that is destructive to returns. The quintile of stocks with the greatest debt issuance underperforms by 5.5% per year. Companies with the highest share issuance — diluting shareholders — underperform by a greater 6.4% per year. The vast majority of small cap stocks engage in these activities. For example, nearly three-quarters of all stocks on the Russell 2000® Index are net diluters of shareholders. Profitability (ROE) and earnings growth tend to be lower overall for small cap companies. Non-cash earnings-to-assets compares the extent to which firms use non-cash accruals to manipulate earnings. There is a tail of companies that do not represent their earnings appropriately.
In order to avoid poor quality companies, we remove stocks based on four themes: Financial Strength, Earnings Quality, Earnings Growth, and Momentum. Financial Strength identifies companies that are overly levered, are issuing debt and equity, and have poor cash flow coverage ratios. Earnings Growth assesses profitability and the trend in the growth of earnings. Earnings Quality measures whether earnings are driven by cash generation or non-cash accruals. Momentum looks at the recent market trend over the last three to nine months, as well as the volatility of the stock, and avoids investments that have been penalized heavily and have excessive volatility.
In the next chart, we evaluate the performance of stocks that fall from highest quality (quintile 1) to lowest quality (quintile 5) according to each theme. In doing so, we generally find that the greatest benefit lies in avoiding the lowest quality stocks. For example, stocks in the lowest quintile of Earnings Quality underperform small cap stocks by 5.2% per year. With a batting average of just 5% in rolling 5-year periods, stocks with the lowest Earnings Quality lose to the market 95% of the time. We see similar results for Financial Strength and Earnings Growth.
OSAM’s multi-factor “Quality” composites vs. Small Cap Universe
Annualized Excess Returns (1/1/1964–5/31/2015)
Unite Quality & Valuation in Portfolio Construction
Now that we have individually established the power of valuation for selection and quality for avoidance, we will demonstrate the power of the interactive effects of these themes in portfolio construction. As shown in the chart below, we start with an equal-weighted universe of all stocks with an inflation-adjusted market capitalization between $200 million to $2 billion. To ensure illiquid names are not driving return in our analysis, we eliminate names with less than an inflation-adjusted $250,000 average daily dollar volume.
Valuation Strategies: Performance (1/1/1979–5/31/2015)
An equal-weighted investment in this small cap universe provides an annualized return of 10.9% from 1979–2015. The market-capitalization-weighted Russell 2000® Value Index, which tilts the universe based on price-to-book, provides a greater 12.7% annualized return. Focusing further on the top decile of price-to-book brings an improvement in return to 13.3%. A significant jump occurs when shifting to the multi-factor “OSAM Value” composite, which returns 17.4%.
Finally, we combine the themes of value and quality by first concentrating on stocks in the cheapest decile of the Value composite and then filtering out stocks that rank poorly on quality and momentum. This improves the overall results of the test to an impressive 18% annualized return. Additionally, the inclusion of quality themes helps lower volatility and risk-adjusted return (Sharpe Ratio). Combining value and quality also improves the consistency of returns as shown by higher base rates (94%).
In the first part of this post, we established that poor coverage by institutional owners and analysts drive inefficiencies in the small cap space. This limited attention specifically favors a scalable, disciplined approach, which is able to identify opportunities much more efficiently than traditional qualitative stock picking. Multi-factor valuation based on earnings and cash flows is preferable to a simple passive or single-factor investment in small cap stocks based on the book value of equities. The nature of small cap stocks lends itself to poorer overall quality, which requires a discerning view to avoid value traps. Liquidity is an important consideration because it can erode excess returns in real world application. While small cap stocks present a greater opportunity for total return, transaction costs significantly limit the amount of manageable assets in the space. Drawing upon a long history of trading in small caps, we believe that effective trade execution is also a key to successful long-term small cap investing.
Whereas this post demonstrates the results of our research on a theoretical basis, it’s worth noting that since March 2004 OSAM has employed a small cap value strategy that “removes weak names through a combination of Financial Strength, Earnings Quality, Earnings Growth, and Momentum and then selects a concentrated portfolio with the cheapest Value composite scores”, which has achieved comparable levels of excess return over the Russell 2000® Value Index livetime since inception (3/1/2004).