SPY has outperformed IWM by 50%

Manage
21

Yuval,

Thanks. We are comparing apples and oranges.

I believe that the two basic styles of the market are small value (represented here by equal weight S&P 600 small cap) and large growth/momentum/FAANG represented by the cap weighted Nasdaq 100 (QQQ).

Furthermore, I like to look at the free cash flow yield (FCF yield) because I believe that it represents a more accurate picture of owner earnings than net income. Of course it has the disadvantage that it’s backwards looking. I count negative income as 0 because the legal structure of corporations protects owners from being liable for losses.

Large Growth
Using these measures, the FCF yield on QQQ went up from less than 2% at the peak of the dot com bubble to a high of about 7.5% in 2010-2012. Now it’s back down to about 4%. Not a bubble (assuming FCF recovers) but not a bargain by any means. Considering the fact that unemployment is at levels last seen in the Great Depression, I think that it would be 7% if not for the Fed’s buying. So there is quite a bit of downside in theory (although I wouldn’t be surprised if that doesn’t play out in practice).

Small Value
On the other hand, the S&P small cap index EW had a FCF yield of about 5% throughout the early 2000’s, about 10% post the GFC, gradually drifted down to a low of about 5% in 2013, where it remained more or less until the 2018 correction. In 2019 it was at ~7.5%.

Now? Its hard to tell. It remains to be seen what earnings will actually be when the dust settles.

Some very rough estimates: SLY (S&P 600) and QQQ are both off about 1/3 from their highs. Assuming that SLY loses 1/3 of its FCF permanently, it yields the same 8% to normalized earnings as before. Assuming that QQQ loses no fcf, it yields about 6%. So, SV is cheaper that LG in the most extreme scenario. But I am not buying yet.

Sources: Public series.
Nasdaq 100 Cap Weighted
S&P 600 EW

Note: In the chart, the spike during the GFC can be disregarded. The current spike can also be disregarded.

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22

This is my seat-of-the-pants explanation. Because I set my limit for large caps at $2 billion in market cap, fewer companies qualified during market downturns, and those companies that did were also the ones that earned the most. So the median income (TTM net income is what I was measuring here) went way up. Basically a lot of the large caps with lousy earnings became small caps during those periods.

23

Why are you using Max(0,FCFYield)? What about all the companies with negative free cash flow? And why the NASDAQ 100? What about all the large-cap NYSE stocks? And why use average? If just one stock has a crazily high FCF yield it’ll shift your numbers radically. The subject of the thread was IWC vs SPY, so why not compare the S&P 500 with the Russell 2000?
Never mind. I’ve done it for you. See these public series.
https://www.portfolio123.com/app/series/summary/11285?mt=8 Small caps have a median yield of between 3% and 4%.
https://www.portfolio123.com/app/series/summary/11284?st=1&mt=8 Large caps have a median yield of between 4% and 6%.

24

Thank you!

25

Yuval, I edited my post to explain some of my reasoning. As a value investor and a financial analyst, I believe that it is the correct way to do it.

[quote]
If just one stock has a crazily high FCF yield it’ll shift your numbers radically.
[/quote]Exactly. And that’s by design.

Let’s say you buy a basket of 3 stocks. Two are up 0, but one is up 3x. Your portfolio would be up 100%. If you use average, it reflects that correctly. But if you use median, it will show a 0 gain. Which measure is correct?

I look at buying cash flow the same way. Let’s say I buy three businesses outright for $100,000 each. One is losing -$100,000, one is breaking even, and the third is making $24,000. Median fcf is $0. Average fcf is -$76,000. Average fcf excluding negative is $8,000. What is the right number? In my mind, I am earning $24,000 on my $300,000 investment. That’s 8%; the same as the average positive fcf.

26

Interesting.

Some theories:
A. Profitable small caps were bought out.
B. High demand for equities allowed a lot of low quality IPOs.

27

% unprofitable all stocks in the U.S. over time.

EDIT: Notice how positive fcf is always less than positive net income. That may be because companies are incentivized to report positive income. fcf ay be the more accurate number.

EDIT 2: My data doesn’t break down stocks into separate categories for large and small. But from what I remember, the vast majority of large cap stocks are profitable. In the small cap space, many are not profitable. That’s a big part of the reason why the Russell 2000 small cap index has so many more stocks than the S&P 600. So, the chart should be highly correlated with the number of unprofitable small caps.

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Another chart, but with the number of stocks.

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I dont know how you can compare the yields of large growth to small value.
Growth is growing and value isn’t growing.

30

Yes and no. Trends over time can tell you something.

Certainly, growth stocks with legitimate business models deserve higher multiples. That’s why it was so surprising when growth was cheaper than value at one point. However, realize that good value stocks get more valuable over time, too. That’s because retained earnings are reinvested. That’s why ROE is growth to a value investor.

31

Chaim -
I have come up with an explanation for why small caps have massively underperformed large caps over the last ten years, but it’s not a great one because if it were true small caps should have underperformed large caps in the 2002 to 2008 period as well, and they didn’t. I still maintain that small caps are not as good a value as large caps; you disagree. I’m grateful to you for the charts of unprofitable companies too. Here’s my question for you: do you have an alternative explanation for why small caps have underperformed large caps over the last ten years?

  • Yuval
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[quote]
Chaim -
I have come up with an explanation for why small caps have massively underperformed large caps over the last ten years, but it’s not a great one because if it were true small caps should have underperformed large caps in the 2002 to 2008 period as well, and they didn’t. I still maintain that small caps are not as good a value as large caps; you disagree. I’m grateful to you for the charts of unprofitable companies too. Here’s my question for you: do you have an alternative explanation for why small caps have underperformed large caps over the last ten years?

  • Yuval
    [/quote]Yes. Not only do I have a theory, but back in 2012 I wrote that I was almost certain that it was going to happen. And my prediction came true. You won’t find me making lots of predictions like that. You also won’t find me saying too often that I am almost certain about stuff in the markets.

I written about my reasoning on this forum a few times.

Basically, there has been a pattern over numerous market cycles that large growth (and by extension the S&P 500) does better at the end of a long bull market. This is observation that has held out of sample for at least two market cycles. This was somewhat of a proof, albeit not a reason.

Furthermore, prices of high quality large cap stocks (such as Google) were trading at PE multiples similar to small caps. Fundamentally, that made no sense. Why should better businesses trade at the same PE as low quality stocks?

At the same time, small caps were almost all fully valued (or close to it). To illustrate, as a financial analyst, collecting value investment ideas from multiple great investors, I had kept a watchlist of stocks that were trading at 1/2 price. I had twenty or more stocks on this list at all times from 2007-2011. But by 2012 I was not finding any stocks trading at half price. This meant that the party was over for small value. As you yourself have observed in the past, small value stocks are not long term holdings. You buy them for the pop and then trade them. But there was no pop left. The juice had been squeezed.

From a behavioral standpoint, I understood that investors were once again fighting the last battle. They remembered vividly that large caps (such as AIG and banks) had failed spectacularly in the GFC. So they did not view large caps as safe. They also remembered the lessons from the dot com crash; to stay away from tech stocks. After all, Microsoft had not gone up in ten years. (What they didn’t realize was that Microsoft had been selling at highly inflated valuations in 2000, and it took ten years or so to grow into its valuations).

But I understood then that eventually the tide was going to turn. I didn’t know when. (Ultimately it took a couple more years for large growth to gather steam and it’s momentum has accelerated).

At this point, investors have again forgotten the hard earned lessons from the 1920’s, 1960’s, 1980’s Japan, and 1990’s; price ultimately matters. Stocks will revert to track earnings. So everyone “knows” that there is no point in owning small value stocks. Proof? The past ten years. FAANG and tech stocks are the place to be. The current attitude is: What is discounted cash flow? Is that something like the failed modern portfolio theory? Hasn’t the recent past dis-proven DCF?

It’s as Templeton said: “Bull markets are born on pessimism, grown on skepticism, mature on optimism, and die on euphoria” I’d guess that this is what he meant by euphoria. “Price? Why does price matter? Buy great companies!”

Right now I am not predicting small value outperformance (although it wouldn’t surprise me). But I would be surprised if small caps will not bounce back faster from the bottom of this bear market, whenever that bottom is going to be.

P.S. Small growth (SG) stocks are often fundamentally different than large growth (LG). A typical SG stock typically has no profits; just a dream. Why would anyone buy those? OTOH, large growth typically is dominated by stocks with an accepted business model and growing rapidly. Those stocks may be great businesses. So biggest argument against them is price. Prices often match or exceed all reasonable expectations for future cash earnings. When that happens risk is highest.

So, in summary, large caps are risky now mostly because of valuations (a reason) and because of the crash (a possible catalyst). Small caps are risky now because of the recession (a reason and a catalyst). In fact, small caps overall are more vulnerable than large caps. So I am still very conservatively positioned. But as usual I am not close to being certain about the near term, in fact, I am not certain about the next ten years either.

33

Chaim -
What you write about is why large growth has outperformed small value. There are all sorts of definitions of growth and value. But what can’t be denied is that large caps have outperformed small caps, growth/value be damned. A lot of small caps are essentially growth stocks. A lot of large caps are essentially value stocks. So if growth is outperforming value, that shouldn’t necessarily mean that large caps are outperforming small caps. Especially if, by at least some metrics, small caps have HIGHER p/e’s than large caps.

I guess my theory is quite different. Small caps used to outperform because they were natural draws for speculative investors. All the innovation was happening in the small-cap space. But with the explosion in venture capital and the fact that large caps are leading high-profile innovations, that’s no longer the case. Couple that with the fact that small caps are poor earners and you’ve got a good recipe for failure. What will it take to turn that around? If venture capital implodes and we get more IPOs, that will help.

We can disagree, but the conversation has been fascinating. Thanks.

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Experienced market veterans have claimed for decades that it’s large growth vs small value. They also predicted that investors would stop caring about price and favor large growth at this stage of the market cycle. Did these predictions come true? Here is a chart.

Capture.PNG

35

Yes, this type of theory becomes quite popular at the end of market cycles. It’s fascinating how history repeats itself. A similar theory was popular in the late 1990’s. Forget small value, they said. All the innovation is in large growth, they said. AOL, Amazon, Microsoft, Yahoo. Names we still remember. Pets.com, TheGlobe.com? They were not small caps.

Studies of IPOs have shown years ago that the largest IPOs (by market cap) do the best. This indicates that disruptive innovations are made by large companies.

Your theory will work–until it doesn’t. I predict another 2000-2005 period starting within the next five years where small value is going to really really outperform. Why? Because valuations matter for large growth, small value, and everything in between. But many investors are forgetting that.

36

I think the obvious problem is say a large growth has a P/E of 30, in 5 years it will be a P/E of 10 at today’s prices.
A small value has a P/E of 5 , in 5 years it will be out of business or have earnings much lower than today. Value stocks for the most part have declining earnings since 2017.

Most value stocks, dare I say, are not that cheap.
Not many stocks pay a dividend of more than 10% (that’s not going to be cut immediately), that is also not having declining earnings.
Even if you get a 10% yield, after tax it’s like 8% yield. Not worth the risk if the earnings decline.

For the most part, if a company just maintains 0% growth forever, they will have declining earnings. Because labor and cogs cost inflation is 2% a year. You basically need to grow or you will die eventually one day.

37

Well, I really really hope you’re right and I’m wrong. That would be fantastic.

And, by the way, I’m still sticking with underpriced microcaps, despite my pessimism.

38

[quote]
I think the obvious problem is say a large growth has a P/E of 30, in 5 years it will be a P/E of 10 at today’s prices.
[/quote]True. When Google was trading at a PE of 15, I was very tempted to buy it. I knew at the time that large growth was set to outperform. But that’s not my game. I was hoping to make more in small caps, and I did. Until mid 2018. But Google is a rare stock. Most fast growers mean revert and underperform expectations.

[quote]
A small value has a P/E of 5 , in 5 years it will be out of business or have earnings much lower than today.
[/quote]Is that really true? It depends on the stock. Mean reversion tells us that today’s slow growing stocks will be stronger tomorrow. (With the caveat that this only applies to profitable stocks).

As a group? Probably. But I am looking for the exceptions. Besides, could it be that value stocks as a group have declined in earnings because the profitable stocks have been bought out? If that is the case, then the decline in earnings does not tell us about the remaining good ones.

[quote]
Most value stocks, dare I say, are not that cheap.
Not many stocks pay a dividend of more than 10% (that’s not going to be cut immediately), that is also not having declining earnings.
Even if you get a 10% yield, after tax it’s like 8% yield. Not worth the risk if the earnings decline.
[/quote]Whatever is not cheap is by definition not a good value. That’s why I have never in vested in the value index. [EDIT: I don’t agree with the way indexes define value, I think I can do better with P123.] All you need is to find a small basket of [truly] very cheap stocks and you are good to go.

[quote]
For the most part, if a company just maintains 0% growth forever, they will have declining earnings. Because labor and cogs cost inflation is 2% a year. You basically need to grow or you will die eventually one day.
[/quote]Right, you need to grow profits about as fast as inflation just to keep from shrinking earnings. But investment growth does not solely depend on earnings growth. Your hypothetical stock should grow as fast as its earnings yield. If you a buy a stock with 2% growth at a P/(owner earnings) of less than 10, you will have very good results. Your growth is 12%+ a year without P/E expansion and you have a free option on P/E expansion (or a buyout). Some of those options will be exercised.

Just to be clear: I am not calling a bottom here yet in small value. I don’t yet know when the bottom will be. But the longer the party lasts for large growth, the bigger the party will be for small value when it’s turn comes.

Business quality and/or growth by itself is not enough of an argument in favor of buying large growth. It’s just the human brain trying to pin a reason on the recent outperformance of large growth. I think that growth/quality has been part of the reason, but the primary reason has been the value of large growth stocks. Yes, large growth stocks were actually an incredibly good value back in 2012 or so. Not because of cheap PEs but because of cheap price to future earnings. Since then large growth has benefited from growth, PE expansion, profit margin expansion, and now safety (since large companies are more likely to survive this recession). My impression is that the news has not yet been priced into the markets, partially because of massive direct government buying. I am not making a prediction as to the timing, but small value will once again have its day in the sun, despite all the arguments now favoring large growth as an asset class.

That said, if I had a reliable system to use for investing in large growth I would have done so a year ago. I don’t. So am being defensive while waiting for the tide to turn.

39

Although I am defending small value, (or at least my version of it), I am not yet pounding the table in favor of small value right now. I do know that it will bounce back one day. I just don’t know exactly when.

My best guess is that small value will bounce the highest off the bottom of this bear market. I don’t know if the outperformance will continue after that after the first nine months to three years. But the longer LG outperforms, the more SV will excel when it gets it’s turn in the sun again.

40

Here is my simple explanation on the subject. It is based on a presentation by John Templeton to a group of us in the early 1990s. Someone asked him what was his strategy. He said it is very simple, the way I got rich was to wait for a recession and then buy every stock under $1 a share. Repeat! When he was most active he said recessions came routinely every four and a half years. I modified his strategy a bit and have used it ever since with amazing success. (Interestingly, this matches some of the conclusions from that article on crisis investing.)

That brings us to the present times. Why have small caps stocks underperformed for a long time? Reason #1) We rarely have recessions anymore! The Fed has tried its best to eliminate them. Reason #2 (a natural outcome of #1): Now, during even the slightest economic softness, the Fed’s policy of zero interest rates and mass stimulation has created zombie (mostly small cap) companies. So, in past recessions, if you had a cheap small company you knew that it was at least a decent company–for it was surviving the recession! (Recessions were a natural cleansing of bad companies–the forest fire analogy.) Now, there are a lot of crappy companies that should have gone bankrupt long ago.

Still, in my opinion, this current recession offers small cap opportunities–but I have modified my base-case strategy (because of reason #2).