Fama and Frensch testet the following factors from 1951 - 2002:
Overall market: 9,84% per year
Small Caps Equal weighted (all stocks get the same percantage of the port no matter of their captitalisation): 16.1% per year
Small Caps value weighted (bic cap stocks get bigger percantage of the port as smaller caps based on capitalisation): 11.98%
PE Ratio Equal weighted: 19.6%
PE Ratio value weighted: 17%
Cashflow Price Ratio equal weighted: 19.6%
Cashflow Price Ratio value weighted: 15,7%
Example on how the ports have been constructed:
July 1951-December 2002
Cashflow < 0; bottom 30%, middle 40%, top 30%; quintiles; deciles. Firms with negative cashflow are in only the Cashflow < 0 portfolio.
Portfolios are formed on CF/P at the end of each June using NYSE breakpoints. The cashflow used in June of year t is total earnings before extraordinary items, plus equity’s share of depreciation, plus deferred taxes (if available) for the last fiscal year end in t-1. P (actually ME) is price times shares outstanding at the end of December of t-1.
All NYSE, AMEX, and NASDAQ stocks for which we have ME for December of t-1 and June of t, and cashflow for calendar year t-1.”
And they tested momentum from 1927 - 2002: 8% more then the average market.
I skimmed the paper. To me, it shows that small stocks exhibit, at a minimum, much larger value and momentum premiums (see charts at the end - p.26 and 27 or so)…across nearly all time periods and global markets studied. That means that small is a robust factor here if we are building a 1-3 factor ranking that attempts to predict forward period returns during this period. You’re pointing out that small alone - as a single factor - isn’t enough according to this paper. Fair enough.
But…that finding depends on the Universe. Do some screener tests. For many standard (or custom made) universes, running a long-short portfolio from 1999 to 2014 only on size will show significant size ‘small premium’ effects over the past 14 years (try it on the SP500 for example). So…either this premium exists or P123 has problems with the screener that need to be fixed ASAP (both are possible). To try this…Go to the screener and run a long-short portfolio with 100 holdings…no slippage, no margin/carry costs. 100% long. 100% short. Quick rank on 1 factor - Mkt Cap. Lower is better. You can do the tests here. The ‘AR%’ is then showing you the small-big factor premium results at various rebalance frequencies. Anything positive indicates some small-big premium. Negative means that big outperformed. You will see significant effects for many universes (SP500, Russell1000, etc). Over many/most subperiods.
@Steve. You keep mentioning that small stocks are way riskier than large stocks when the market turns. Meaning we will have much higher st. dev. and DD’s, I guess?
Over the P123 database periods…Russell 2000 ETF earned 8’ish%/yr with peak DD of -58% and St.Dev of 25%. For Sortino of .22. Over same period for SP500 ETF, earned 4.53%/yr, -55% DD, 20.3% St. Dev. and .04 Sortino. So…comparing the market cap weighted indexes of ‘small’ vs. ‘big’ US stocks…not really a lot more risk in small over this period, and investors were compensated for it. But…if I look at just the smallest 100 stocks in the Russell2000 with $1MM in trading liquidity, close>$2 and MktCap>50, I get a peak DD of 85% or so. So…blindly buying a basket of this very small set of 100 stocks is much riskier than the higher size end of the small caps. But it is only really in this very small microcap space that we see this. And or with a very small ‘basket.’ The top 100 stocks from the Russell2000 (on mkt. cap basis) have about the same St. Dev (22%'ish vs. 19%'ish for equal wtd. SP500 plus div) and same peak DD roughly as the SP500. And about the same return on an equal weighted basis. So…small isn’t really more risky, unless we’re talking really small.
You still agree that some allocation to small stocks makes sense for most portfolios, right? You just also want to see large cap in there too?
Steve said: [quote]
The point is not “how much better smallcaps perform over time”, the point is “how poor you are going to be after the next bear market”.
[/quote] Come on now Steve, in my very simple Sims above the small caps actually lost significantly less than the large caps in the first recession and slightly less than the large caps in the second recession. If it is that easy to do with a 2 factor ranking system, no buy rules, and 1 sell rule, your comment is misleading. With the P123 tools members can avoid going poor in the next bear market.
My point is that liquidity is your friend in times of crisis. Lack of liquidity is your enemy. You can do all the paper analysis you want but it comes down to being able to liquidate your positions when you have to. Small and microcaps are difficult to trade at the best of times. Don’t get caught holding them during the worst.
Most financial advisors will tell you that its good to allocate 10% is to risky securities for a little extra sizzle. But don’t think that putting your entire nest egg into a bunch of supposedly diversified smallcap systems is a good way to go. Because they aren’t really all that diversified.
…That depends on the size of your portfolio… I agree with denny, small caps are give a great edge with a port between 50k - 200k…
A small port gives a competetive advantage, that can be utualized…
"I set up 2 simple 100 stock Sims to compare the best large caps to the best small caps using a 2 factor ranking system, MktCap (lower is better, 70% weight), and earnings/share (EPSExclXorTTM higher is better 30% weight). They have no fees, rebalances weekly, sells all stock every rebalance, and allows sold stocks to be re-bought. "
Denny - P123 simulations don’t take into account liquidity and in fact no simulation program could without intra-day bid-ask spreads and depth information. And in today’s marketplace with flash orders, it is practically impossible to determine the real spread. But in any case, most theorists apply some sort of liquidity discount value which would significantly alter your results and conclusions for that matter. In the case of market stress, bid-ask spreads will widen substantially due to supply-demand imbalance and also risk to market-makers. BTW - the discount depends not only on liquidity but also turnover. So high turnover, low liquidity stocks systems should have a much higher value discount. If you are holding for a long period of time then the discount would be less. But are you willing to hold through a market meltdown? I think not.
Speaking of smallcaps in meltdowns, how did people here fare in 2008/2009? Did people get out of the market before it got very illiquid? Did they have to sit through it all? Did some lose nearly everything?
Are there some good forum threads to read about experiences during that time? (The forums are quite hard to search)
I stayed in the whole way up and down and up. On a calendar basis I lost 16% in 2008, but earned more than 100% in 2009. My 2008/9 peak-trough drawdown was greater than the market tho, about 70%, but due to having run things up in a very dreamy way early in the year, end 2008 vs Jan 1 2008 wasn’t so bad at all.
Maybe small caps lose a bit more in a bear year, say 5% more than big caps, but my small cap ports easily outperform by 10%+ a year in a bull, there’s 8 bull years for 2 bears on average, I’ll take small caps everyday.
