Small Cap Value Stocks Have The Best Returns, But Can You Stomach The Catch?

August 15, 2016

Small Cap Value Stocks Have The Best Returns, But Can You Stomach The Catch?

  • Historically, small cap value stocks are the best performers.
  • They don’t trade in sync with the market and often are waiting to be discovered.
  • The “waiting to be discovered” period can last for a few years.

Introduction

Almost a month ago we discussed how, from a risk-reward perspective given current valuations and historic performance, it isn’t a smart idea to invest in small cap growth stocks at the moment. Today we are going to discuss small cap value stocks to see if they will fare better on our long-term risk-reward scale.

Small Cap Value

In order to be categorized as a small cap value stock, a company has to have a market capitalization below $2.5 billion and its stock price has to trade below its book value (where possible, or have the lowest book value).

There are several benefits to having a small market capitalization. One is that a company is then always a takeover target and as we discussed last week, that can bring about instant returns when an acquisition is announced. Other benefits include growth prospects as it is easier to grow when you are smaller. For stock pickers like us, it is always a benefit when a company is a small cap because it is less frequently, or even not, followed by analysts, and thorough due diligence pays off as sooner or later the market recognizes good companies even amongst small caps.

On the value side, when a company is trading below its book value it means that the risks of investing are limited because in the case of a business liquidation or bankruptcy, there are enough assets to cover all stakeholders. However, proper due diligence here is essential as there is a big difference between having lots of fixed assets on your balance sheet and having lots of goodwill. In difficult times, goodwill is impaired as the acquisition that created it was obviously a mistake while fixed assets like real estate are of real value on the balance sheet. Researching beyond the balance sheet can bring further benefits as by understanding the story behind a property, plant and equipment account, one can discover that some buildings are completely depreciated and not even on the balance sheet. Such a situation with no analysts following a company is a real gem, but it takes a lot of research of diligently going through every single small cap in the stocks universe.

Small Cap Value – Historical Performance

For those investors who don’t have the time to research small caps in detail, diversified investing into small cap value stocks has been the best thing to do over the past 40 years. Investing into U.S. small cap value stocks would have outperformed all other investment options.

figure 1 size and value
Figure 1: Investing by size and value – performance since 1979. Source: Author’s calculations.

$100 invested into small cap value stocks at the end of 1979 would have returned $11,027 today, while investing in mid cap value stocks would have returned $9,605 in the same time frame, in the S&P 500, $5,199, and in small cap growth stocks only $3,216.

This outperformance is nothing new. Back in 1992, Fama and French developed their famous three factor model—which earned them the Nobel prize (French, unfortunately passed away and was not formally awarded a Nobel)—where they found that value and size give the highest premiums to stock returns. Twenty-four years later, the story should be the same. The iShares S&P Small-Cap 600 Value ETF (IJS) has had an average return 9.48% since its inception in 2000, thus no matter when the measuring started, this strategy outperforms other strategies.

The current PE ratio of the iShares S&P Small-Cap 600 Value ETF is 19.21 which is the same as the iShares Core S&P 500 ETF (IVV), but the difference lies in the price-to-book value which is 1.64 with small cap value stocks, 2.88 with the S&P 500 and 2.92 with the small cap growth ETF. From a fundamental perspective, this is where the difference lies.

Why Do Small Cap Value Stocks Outperform? 

The are many answers to this question. To find them, you have to dig in the dirt and not many analysts are willing to do that as it is easier to follow the crowd with big names. Big investment funds have to wait for a company to reach a large market capitalization to invest in it, but by then the major profits have already been accounted for. If you are an investment manager and you make a mistake by overpaying for a large cap, there will be no hard feelings as everybody else did so as well, but if you recommend a small cap and the story doesn’t end well, you will probably be fired.

The last reason is that value lowers investing risk. If the business doesn’t end well, there are always assets to sell to cover the losses. Therefore, small cap value stocks trade at a premium which ultimately delivers higher returns.

What’s The Catch?

Investing in small cap value stocks comes with a catch that many investors don’t have the stomach for. The catch is that small cap value stocks tend to have a mind of their own and don’t move in sync with the S&P 500. For example, in 2015 the S&P 500 returned 1.3% while small cap value stocks had a return of -6.84%. The same was true in 2014 when the S&P 500 was up 14% while small cap value stocks were only up 6.5%. In 2007, the S&P 500 was up 5% while small cap value stocks lost 8%. How would you feel if when talking to your neighbor, they are up more than 20% in the last two years while you have a negative return?

The thing is that small cap value stocks have to first be discovered by the masses, and only then, when they become trendy, do they boom by getting a fair market valuation. Therefore, an investor may wait for a long time and underperform—like in 2014 and 2015—but sooner or later things change. Year-to-date, small cap value stocks are trendy again and are up 13.6% compared to the S&P 500’s 6.5%.

Conclusion

Investing in small cap value stocks is not for everybody but it delivers the best returns in the long term. The low liquidity, higher uncertainty and general unwillingness to research small caps means a higher premium which in the end, brings about higher returns. Investors who are ready to invest in small cap values will be rewarded in the long term.

In an environment like we’re in now with lots of monetary stimulus, value might be the way to go as assets increase in value in inflationary times. We don’t see inflation yet, but it is bound to happen sooner or later. Growth stocks with high debt levels will be the first ones to suffer when higher interest rates arrive, and historically are the worst performers. Therefore, look into your portfolio and if you don’t have small cap value stocks, be sure to include some.


On Friday we attempted to send you a report Sven had written but had some issues with the links. It just so happens the company featured in this report happens to be a small cap value stock in the metals and mining space that we believe has yet to be discovered by the market. To access this free report ($49 value) click here, and to access the most recent update on the featured company click here.

Many of you also may not have received yesterday’s Sunday Edition featuring a reprint from Thomas Moore’s Rebel Income newsletter. In yesterday’s issue, Thomas discussed why stock assignments aren’t a bad thing and how to take advantage of them. To access the Sunday Edition, click here.