Introduction
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After rallying earlier this year, small caps have gotten crushed over the last few weeks (figure 1). This is normal during the slowing phase of the economic cycle since small caps have more domestic and cyclical exposure and perhaps less certain financial stability (see Tactical Allocation Over the Cycle). It may also be deserved.
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There has been a growing number of unprofitable small companies (figure 2) that have received, but more than likely should not have, a life line. This is typical during the latter stages of an economic cycle, but it is not necessarily prudent for the long-term. Plus, the median small cap company ($100 million to $5 billion market capitalization) is more expensive than the median large cap company (figure 3) (> $5 billion in market capitalization) despite its widening net margin deficit differential (figure 4). People have been excited to take risk.
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Maybe the correction will shake out the weak small companies from the strong and lead to a more rational market? The median unprofitable small cap stock is down 10.5% from the market peak on 9/20/18, while the median profitable company is down 7.9%.
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The cheap profitable small cap company tends to outperform over time, but investors have preferred the high flyers over the last several years. The P/S ratio of the median profitable small company is at about its lowest point of the last decade relative to the median unprofitable firm (figure 5). Plus, relative to large caps, it now trades at the same P/S and has a similar net margin (figure 6); these profitable small stocks normally trade at a premium, likely due to a perceived, if not realized, above average growth prospects.
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Leadership in Small Caps is Cyclical
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Due to cycles in psychology (see The Expectations Clock: A Model for Cycles and Sentiment), during the mid to latter parts of an economic cycle, it is quite typical for new companies to be formed, and old companies to just barely hang around, that will not survive long-term. People get excited, especially if the companies are in technology, health care, or some other equally as “thrilling” growth space. Investors finance these companies with equity and/or debt with a hope that they knock the cover off the ball and hit a home run before they strike out (in the spirit of the World Series that just concluded…). Private equity and VC funding is very robust, IPO activity is elevated, and debt to asset ratios have risen for small and large caps over the last seven years (figure 7).
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However, eventually, there is a day of reckoning. Markets become more rational. The losers (money losers that is) underperform.
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These cycles are dependent on the market, which is dependent on the economy, and on psychology – or expectations – which is implied in valuation.
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Figure 8 shows forward 12-month returns of a sort of profitable minus unprofitable small firms overlaid on an equal-weighted index of returns for small cap stocks. When small cap returns are elevated, such as during a strong economy, the performance of profitable small cap companies, relative to unprofitable companies, deteriorates. On average, they still outperform over the entire period, but the advantage wanes during good times. As you can see in figures 8 and 9, over the last few years profitable companies have performed only in-line with unprofitable firms during a stellar stock market environment.
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Returns are quite dependent on psychology. We can judge expectations with valuation multiples.
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Recall that the P/S multiple is directly related to profitability. The more earnings that a dollar of sales generates, the higher investors are willing to pay per dollar of sales (i.e., the higher P/S ratio). However, the P/S multiple is also dependent on perceptions of growth and risk. Investors are normally willing to pay a higher P/S if they expect high sales growth and/or lower risk (see equation 5).
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After a sustained period when profitable companies have not performed sufficiently well versus unprofitable firms, profitable small firm P/S multiples have come down versus their unprofitable counterparts (see the dark bars in figure 9). Notice that low valuation precedes improving relative returns for profitable companies (see the light bars in figure 9). The high valuation discount and past stock returns (if lower going forward) have set up profitable companies to perform relatively well going forward. Well, I’d expect this if the economy continues to slow, but the current hype and excitement to take risk in just about all asset classes (see figures 7 and 8 in Rising Rates Catalyst for, Not Cause of Correction?) could reignite to a true bubble if the economic expansion continues for several more years.
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Another interesting tidbit from figure 9 is that profitable small cap companies normally trade at a discount to unprofitable firms. The market is generally enthusiastic about growth prospects for the money losers since, all else equal, they should trade at a discount because of their above-average risk and below-average profitability.
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Cheap, Profitable, Small Cap Companies Outperform Over the Long-Term
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Investing in small cap stocks is not without above-average risks. First, these stocks have a higher likelihood of being unprofitable (28.4% security-periods versus 7.8% for large caps since March 1999) and do not earn even half the net profit margin of large companies (figure 4). Perhaps the small cap universe also includes more young and less established businesses and companies with fewer product lines. They have a narrower geographic presence and tend to be more cyclical.
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However, one can reduce one’s risk and improve one’s odds of success in small cap investing by focusing on profitable cheap small cap stocks. From 3/31/1999 through 9/30/2018, small cap companies earned a median return of 7.64% per annum while large cap stocks earned 10.39%; however, cheap profitable small firms earned 12.64%. This is even ahead of cheap large profitable companies (12.36%). Overall, profitable small caps earned 10.35% per year, which is still behind profitable large caps (11.82%). Note that these returns are equal weighted, the portfolios are rebalanced every three months, and the sorting of valuation (high, mid, and low) is within FactSet sectors so the returns do not have sector biases.
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Figures 10-12 show the return and risk metrics for small cap companies sorted on their profitability and P/S valuation. Both cheap and the profitable companies significantly outperform expensive and unprofitable companies over the long-term, respectively. Although low P/S stocks have higher risk, the profitable companies have half the volatility of unprofitable stocks and a much lower beta. Even on a risk-adjusted return basis (Sharpe Ratio), low P/S stocks are still best.
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Furthermore, excess returns are not driven by outlier periods. In 75% of the one-year periods and 87% of the two-year periods, profitable companies outperform the universe. For cheap companies, the odds of outperformance rise to 79% and 96% for 12-month and 24-month periods, respectively.
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It Works in Most Market Environments
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As noted earlier, in rising markets, profitable firms tend to generate alpha less frequently than in declining markets, even over short periods. Equal-weighted small cap universe returns were positive in 62.8% of quarterly periods since March 1999. Profitable firms outperformed in 53.1% of the quarterly up markets. However, they outperformed in 86.2% of down – risk-off – markets. Thus, their recent outperformance over the last month+ when returns were down is to be expected. Their overall hit ratio of 65.4% in all markets is also not too shabby.
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Turning to cheap companies, they outperformed in 71.8% of the quarters, and outperformance rose to 81.6% in down markets and was still a very decent 55.2% in positive return environments.
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It Works in Every Sector
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You may be thinking that positive alpha by investing in cheap quality (money making) small cap firms cannot work in every sector. Take, for instance, technology and health care. Maybe small companies in these areas are unprofitable and perhaps expensive because of their substantial growth potential. That still leads to outperformance, right? Nope. Investors with those expectations are engaging in wishful thinking. I am sure some of the firms outperform (see Thinking About Technology), but for the median small company, returns are low for unprofitable expensive firms even in the technology and health care sectors. Profitable and cheap small cap investing works everywhere (figures 15-17).
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Cheap, Profitable, High Margin, Earnings and Dividend Growers Outperform
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The return of a stock is a function of growth, change in valuation multiples (driven by fundamentals and/or psychology), and dividends. It may not surprise you that adding earnings and dividend growth improves the profitability and cheap screens discussed above. Figure 18 shows that valuation, earnings per share (EPS) growth, and dividend per share growth all improve the profitability screen. Also, for those deep value investors out there, note that buying companies that have high margins and solid EPS and dividend growth are better than just searching for cheap companies alone. Thus, look for cheap companies with a catalyst for improvement.
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However, high margin cheap companies are not the norm. Like today, cheap companies (figure 20) ordinarily have lower margins than expensive firms (figure 19). However, figure 19 implies that margins for the expensive companies are turning down, while figure 20 shows that margins for inexpensive stocks are on the rise. Investors have much hope for those premium priced stocks. I tend to like to place my money on lower expectations stocks that are improving or are solidly positioned. Although, beware that low P/S stocks have increased their leverage quite a bit during this cycle (figure 7).
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Cheap companies are a much better deal than in the past (in comparison to expensive companies) (figure 21). Plus, the margin advantage for the expensive companies is deteriorating (figure 21). Assuming the cheap firms are not value traps where their improving margins roll over, and likewise where the expensive higher, but deteriorating, margin companies are not about to improve, this could represent a good time to purchase the cheapest stocks.
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