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The Small Cap – Value Equity Hybrid Model?

[By Staff Reporters]

Modern physician-investors are aware of the financial research that suggests a “small-firm effect,” which shows that stocks of smaller companies may outperform both large firms and the overall market. This seems true, in a stable economy, even after adjusting for the additional risk. The Research also supports buying inexpensive, out-of-favor companies whose returns also significantly exceed the overall market. But, how about combining the two strategies to turbo-charge returns in the modern unstable era?

The Initial Thesis

This was the thesis of an article by Lawrence Creatura and Alyssa Ehrman, entitled “Finding Treasure in Small-Cap Value Stocks” [NAPFA Advisor, back in October 1996, pp.1-10, National Association of Personal Financial Advisors.

The authors explained how value stocks are created by money managers driven by clients to focus on stocks currently in favor and by investors failing to recognize a difference between a “good company” and a “good stock.” Of course, the stock of many good companies is down today, and researchers have demonstrated that “star companies” have underperformed a portfolio of “un-excellent” companies with virtually the same level of risk by some 11% per year; until now!

Small Cap Stocks

Small-cap stocks tend to be undervalued because generally Wall Street does not bother monitoring them and, accordingly, broadcasting positive events to potential investors. Also, managers of large portfolios are virtually excluded from the small-cap stock market because of the minor effect they could have on those portfolios. Most investors tend to shy away from small stocks that trade less frequently than large stocks and which can cause a lack of liquidity; or exacerbate same today.

Small Cap – Value Hybrid

Research on combining the disciplines of small-cap stock investing and value stock investing is still in its infancy. Of particular note is the Fama/French study conducted in 1992, which showed that small, low price-to-book value stocks outperformed larger, higher valued counterparts from 1963 to 1990. They also concluded that size and value do a better job of explaining variation in stock returns than more traditional methods. The authors expanded on the simplistic price-to-book ratio used to identify value stocks by weeding out firms with symptoms of financial weakness. By so doing, they were able to generate annual returns during 1976–1994 in the 18–27% range.

Assessment

All of the above is fine, but what about today? Investing in small, unknown companies selling at discount valuations is not for every physician-investor. But, the potential returns may be worth the effort – and only time will tell.

Conclusion

What do you think? Let us know what’s on your mind with a post, opinion or comment. Is this really a recipe for success, or investing failure? And, feel free to review our top-left column, and top-right sidebar materials, links, URLs and related websites, too. Then, subscribe to the ME-P. It is fast, free and secure.

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Filed under: Investing, Portfolio Management | Tagged: small cap stocks, value stocks | 6 Comments »