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5 Arguments for Small Cap Value Stocks

At its core, Joel Greenblatt's Magic Formula Investing (MFI) strategy is a value-based, mechanically driven stock picking strategy. A key to success with MFI is not to filter out small-cap stocks from it. In fact, including stocks with a minimum market cap of $50 million far outperformed limiting your investment to stocks with at least a $1 billion market cap. The difference was amazing. With the small-caps, MFI returned over 30% annually over a 17-year period, while without them, the return was much lower (but still good) at a about 20% a year! Here are 5 reasons why small cap, value investing should be a part of every portfolio, Magic Formula or otherwise:

1) They Outperform Every Other Class of Stock. Period.

Ibbotson Associates analyzed data from 1926 to 1997 and concluded that small cap value stocks outperformed the general market by 4.3% annually - more than any other class of stocks. Vanguard has published data that shows that, from 1927-2004, small cap value outperformed large cap value, blended, and growth portfolios. A Fama and French study shows this class outperforms all others in recessionary periods as well. Another study by Fund Evaluation Group shows that small cap value has outperformed every other group, and by a wide margin. Recently, MagicDiligence reviewed a historical study by Tweedy Browne, and in that study the stocks with the smallest market capitalizations always outperformed larger market cap classes, even when filtered by the same statistical criteria.

If we want the best returns for our portfolios, we have to invest in the best performing class of stocks.

2) The Market's Valuation of Small Cap Stocks Is Inefficient

Stock analysts overwhelmingly cover large, well known companies. Their clients prefer to be in stocks of companies they know, and the investment firms they work for are forced to purchase large cap stocks so as not to exceed statutes by owning too much of a firm. When funds are operating with billions of dollars of assets, it doesn't make sense to invest in small companies - any investment returns from these will not materially affect the fund's performance because the position is too small. The business press as well tends to focus solely on these large-cap stocks.

One of the best books ever written on investing, Peter Lynch's One Up On Wall Street , explains this phenomena well. Lynch earned stellar returns running Fidelity's Magellan (FMAGX) fund by buying hundreds upon hundreds of small positions in promising small cap stocks and holding them until the market realized their value.

Small cap stocks are valued inefficiently because of the lack of research on them, leading to misunderstanding of a company's business or prospects. Compare the 20 analysts following $30 billion dollar General Dynamics (GD) to the 1 analyst that follows $150 million PRGX Global (PRGX). Which one is more likely to be mis-priced? Add to this the general investment community's unwillingness to invest in small caps, and you have a perfectly inefficient market for them, leading to bargains.

If we want the best returns for our portfolios, we have to take advantage of inefficiencies in the system.

3) Small Caps Can Become Big Caps

This one is obvious - you're not going to find the next Microsoft (MSFT) or Wal-Mart (WMT) by investing in Microsoft and Wal-Mart! When Microsoft started trading on the NASDAQ in 1986, its market capitalization was about 700 million. Today, it's worth 273 billion - giving you back your initial investment 390 times over (and that's not including dividends!).

Relating to point #2, once small cap stocks grow to a certain size, institutions and mutual funds can safely invest in them without worrying about statutory regulations or problems of scale. This leads to an influx of institutional money, sending stock prices up even farther. As market cap grows, these stocks get added to various indexes, which leads to investment by index funds that track them.

Small caps by their very nature have more and larger avenues of growth than large capitalization stocks. This, plus the intricacies of the financial markets, give them several advantageous characteristics for share price appreciation.

If we want the best returns for our portfolios, we need to own the best opportunities for revenue and earnings growth.

4) Small Caps Are Attractive Buyout Bait

Large companies are always struggling to deliver growth to their shareholders. Adding meaningful growth to a company with billions of dollars in revenues and earnings is not easily done. These large companies are often bureaucratic nightmares, slow to adapt with new trends and not nimble enough to stay ahead of changing markets.

Instead of taking the time, patience, and effort to develop new businesses, these cash rich mega-corporations often turn to acquisition as a quick fix for growth. Also, private equity groups will often buy these companies to restructure and then take them public again, reaping a big windfall. Buying small companies, even at a significant premium to market price, is often a drop in the bucket that delivers new opportunities in an instant. Take a look at some recent Magic Formula small-cap buyouts:

Bare Escentuals - bought for a 40% premium in January.

Virgin Mobile - bought for a 31% premium last August.

Allion Healthcare - bought for a 30% premium last October.

These are just a few examples. Small caps get acquired for significant premiums very frequently. If we want the best returns for our portfolios, we have to position ourselves for big buyout profits.

5) Warren Buffett Says So

No less an authority than Warren Buffett himself has guaranteed that he could earn 50% annual returns investing sums of around 1 million. How would he do this?

"...look for small securities in your area of competence where you can understand the business"

If we want the best returns for our portfolios, we'd be wise to listen to the world's greatest investor!

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Disclosure: Steve owns no stocks referenced here.

Joel Greenblatt and MagicFormulaInvesting.com are not associated in any way with this website. Neither Mr. Greenblatt or MagicFormulaInvesting.com endorse this website's investment opinions, strategy, or products. Investment recommendations on this website are not chosen by Mr. Greenblatt, nor are they based on Mr. Greenblatt's proprietary investment model, and are not chosen by MagicFormulaInvesting.com. Magic Formula® is a registered trademark of MagicFormulaInvesting.com, which has no connection to this website. The information on this website is for informational purposes only and solely represents the views and opinions of the author. No warranty is provided or implied as to the accuracy, completeness, or timeliness of this information. This information may not be construed as investment advice of any kind, nor can it be relied upon as the basis for stock trades. Alexander Online Properties LLC, the proprietor of this website, is not responsible in any way for losses or damages resulting from the use of this information. Alexander Online Properties LLC is not a registered investment advisor. All logos are trademarked properties of their respective companies.

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