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An investor invested in 100% equities is often told to consider adding a bond allocation, especially if they admit to being a little risk averse. But what about the investor who desires risk? What are their options besides speculative individual stocks and, well, ‘options’? Something more diversified?
The answer is to tilt a special class of stocks empirically shown to outperform its peers: small cap value. [Reminder: value here means ‘cheap’, measured by price relative to book value.]
This post will collect some data points and qualitative arguments in favor of including a allocation to SCV in your portfolio beyond that of a total stock market index fund.
How do Small Cap Stocks (growth or value) Perform After Recessions
In this figure, we look at the average return among the 25 worst monthly or quarterly periods for small caps. We see on average a 23% decline in the trailing month, followed by average annualized outperformance of 6-8% above the large cap stocks, which already average 5-8% annualized returns over the next decade. Source
From another source:
As the data in the chart below show, small caps (as represented by the Russell 2000® Index) led both large caps (S&P 500®) and mid caps (Russell Mid Cap®) following the last six recessions, returning over 31% on average the following year. At the same time, small-cap returns during those recessions averaged a relatively resilient return of roughly -4%.
But even outside of recessions, the outperformance is robust across many decades, though. Another graph, and another.
Why target cheaper stocks (value, not growth) ?
Here are the excess returns (annualized over 1964-2017) of small cap stocks sorted by the cheapness: figure. The cheapest stocks are on the left. Source
This has been validated in the literature, for example by the AQR paper “Size Matters, If You Control Your Junk”. Essentially, small cap stocks contain a lot of ‘junk,’ especially among the small cap growth class. [Note: By growth, we use the academic definition of high price / (book value).]
Thus, I would not recommend targeting small cap growth in particular. Growth really just means expensive, and what the data shows is targeting cheaper stocks (value) and applying quality filters like profitability requirements yields better returns.
Why target small cap value now or in the near future?
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US small cap value is relatively insulated from the broader global economy, unlike the enormous multinational firms dominating the S&P 500. They do not face the currency risks that are currently hitting large cap company’s revenues. Source and source.
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Right now, the problem in the US economy is its strong labor market. Small cap value stocks see more earnings growth (relative to large firms) in such periods.
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Expected earnings for small caps from this source.
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Returns to expect given these valuations in small caps. (Same link)
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“In 2022 small caps suffered their worst first-half drawdown since the inception of the Russell 2000® Index in 1978, falling 23.4%.” Source.
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They are at historically cheap levels: figure. In this table, we see the ratio of valuations of large cap to small cap stocks. [Higher = small cap is cheaper]. Source.
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Here is a measure of the cheapness of value stocks (large or small) compared to growth. We are in a very expensive period historically speaking. Source.
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Another graph of relative valuation and one more. [The y-axes are flipped relative to each other] Source.
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A figure from Bank of America. Source.
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I made an extensive post a few months back with more statistics like this. I’ll include a few of those quotes:
Value stocks look like a heck of a value right now! Look at it this way. As of yesterday, value stocks have a forward P/E of 13.4, against growth stocks at 22.4. The ratio is 0.57. To get back to the historical average ratio of 0.75, and assuming stable earnings, value stocks would have to rise by about 30 per cent, or growth stocks would have to fall by over 20 per cent, or some combination of both. A little mean reversion here would mean a lot of outperformance for value.
Source
While it is true that earnings of large growth stocks have grown faster than earnings of small-cap value stocks — Avantis estimated that large growth earnings grew by approximately 194 percent between January 2010 and July 2021 versus an earnings increase of 177 percent for small value stocks — the differential was less than 2 percent per year. That differential is a lot smaller than what would have been the expected differential, and certainly cannot explain the fact that the return to large growth stocks was 492 percent versus the 181 percent return to small value stocks over that same period.
Source
Goldman Sachs analyst:
Meanwhile, small cap stocks trade at much more attractive valuation levels than large-caps, according to the note. The S&P SmallCap 600 trades at a P/E multiple of 11x, which is near its cheapest level of the last 30 years. “This multiple also represents a 30% discount to the S&P 500,” Kostin said. That’s the largest discount since the dot-com bubble, and if earnings don’t deteriorate meaningfully from here, it could represent a big opportunity for investors.
Source
Cheapness is even more pronounced in Europe
Arnold also writes “value stocks in Europe are currently trading on lower PEs than they were five years ago . . . there are very few, if any, parts of developed market equities that the market is so pessimistic about that they’ve actually de-rated over the last five years.”
On top of the gap between the valuation of European growth and value, there is the gap between US value and European value: “The Russell 1000 value index is a 16.5 forward PE, while the equivalent in Europe is on 11, an enormous differential in its own right. A cheap stock in the US is held in much higher regard than a cheap stock in Europe. Value stocks in Europe are the unloved of the unloved!”
Finally, Arnold writes that “over the last five years Europe’s cheapest companies have delivered more profit growth than their growth counterparts so over that 5 year period the real growth stocks in Europe, in terms of fundamentals anyway, have been the value stocks!”
Source
Another valuation graph for Europe valuations
It’s a good hedge if there is a decade stagnation of the broader markets
After Japan’s bubble burst, from 1990 to 2019, Japanese total country returns averaged 0.6%. Japanese small cap value averaged 5.13% and Japanese value stocks averaged 4%. During 2000-2010, US small cap value grew 7.94% on average and US value stocks grew 4.56% on average, in contrast to a declining/flat S&P 500.
Source: Ben Felix’s various videos on small cap value.
You aren’t just tilting a riskier asset class, you’re tilting something that is less correlated to the broader market than your typical stock holdings. Hedge yourselves against a lost decade with this asset class.
But why add if VTI already has small cap value inside it?
Because market weights aren’t gospel, and just as someone with less risk tolerance adds bonds, someone with more can add small cap value. VTI places 3% of its allocation into the SCV category. How about make it 10%?
Ticker recommendations:
I use AVUV/AVDV personally for US small cap value and ex-US developed small cap value. Some people also use VIOV or VBR. You could of course pick your own stocks, but the risk is definitely amplified.
I explain in this post how Avantis (who created AVUV and AVDV) approach their ETFs. They already use quality filters to make sure you avoid junk while still getting a diversified exposure.
They look at profitability (measured by profits/book equity) as well as valuation (price/book equity). They also account for bias from ‘goodwill,’ which pushes up book equity after mergers/acquisitions. This way, you target companies that organically grow. They also target companies with low investment rates, because it turns out that small cap growth companies “tend to raise capital when their discount rates are low (meaning their prices are high relative to fundamentals) causing subsequent underperformance.” And they tend to give weight to momentum, because you shouldn’t just throw out a company from an index because it is doing too well. Thus, you get a diversified (>600 companies in AVUV) exposure to some of the cheapest, small cap companies out there, that are highly profitable, organically growing, invest conservatively, and (may) have positive momentum. In contrast, the S&P 500 is highly dominated by a few enormously sized companies that engage in large amounts of acquisitions. Not that that’s a bad thing.
You can read about their approach to investing here.
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