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What role does value play when investing in small cap stocks? The paper, Size, Value and Momentum in International Stock Returns (Fama and French), offers some evidence as to excess gains in small value stocks around the world.

In brief, Fama and French formed portfolios according to size (5 categories) and book to market ratios (5 categories) for a 5x5 sorting with 25 portfolios in total. The smallest market capitalization and highest book to market portfolio delivered strong results compared to the market. When tested between November 1990 and March 2011, these small value stocks resulted in the following monthly excess gains:

  • Globally = 1.12%
  • North America = 1.42%
  • Europe = 0.88%
  • Japan = 0.22%
  • Asia Pacific = 1.61%

Creating an Actionable Trading Strategy

Simply saying that small value stocks have historically resulted in excess profit does little in the way of an actionable trading strategy. If this is as far as we take it, then we might be inclined to invest in the Russell 2000 index (the ETF symbol IWM) or the Russell 2000 Value index (the ETF symbol IWN). From November 2001 to November 2011, the following capital gains have been recorded (derived from data at Barchart.com):

  • Russell 3000 Index (IWV) = 17%
  • Russell 2000 Index = 59.13%
  • Russell 2000 Value Index = 77.22% (beginning in January 2003)

It should be noted that if you track the Russell 2000 index from January 2003 until November 2011, the capital gains jump up to 97%. This is troubling for value investors.

*ETF funds may have slightly results than the underlying index

Using a More Complete Value Ranking System

Instead of using the Russell methodology for picking value stocks, we will utilize a basic value ranking system from Portfolio123. This system gives higher ranks for the following: lower trailing and forward P/E ratios, lower PEG ratios, lower trailing price to sales, lower trailing price to free cash flow, lower price to book ratios.

Does our more complete picture of value result in higher excess gain when judiciously trading in the Russell 2000 universe(or the Portfolio123 approximation of it)? Our simple test will be to re-balancing our portfolio quarterly including the companies in the bottom 5% of our value ranking (which will be roughly 100 stocks out of the 2000 company universe).

The bottom 5% rank of the value category results in a total of 51.6% loss in 10 years time. We will repeat the test keeping the top 5% of small value stocks.

In 10 years, we are up a total of 303.9% by staying invested in the top 5% of this simple value rank. Can we squeeze a little more gain out of this?

The Fama and French paper recognized reported on excess gains associated with momentum, or stocks that have previously outperformed the market. We will use a 6-month trailing period, which is one of the recommended time frames in the various papers on momentum (3,6,9,and 12 months). Instead of targeting the highest momentum gainers, we will simply remove the bottom 50% momentum losers (removing the bottom 50% of stocks when tracking total gain over the previous 26 weeks). Momentum losers have a higher degree of correlation to subsequent losers than do high momentum stocks to subsequent winners.

The percent return is 499.2% in 10 years time which is a 19.61% compound annual growth rate.

To test this for robustness, we buy with 3 month holding periods randomly over the past 10 years, over 500 times. Our average 3 month gain is 3% higher than the market, or 4.59% total. Non-compounding, this works out to over 18%, which is in line with our previous results (Of course transaction fees, slippage and dividend gains have not been taken into consideration, and these will have considerable impact when trading smaller stocks quarterly).

Which stocks are making the list today?

Ticker

Name

Trailing P/E

Trailing P/S

Pr2BookQ

Yield

(PL)

Protective Life Corp.

5.64

0.56

0.43

3.02

(AEL)

American Equity Investment Life Holdings

15.95

0.54

0.47

0.92

(VOXX)

Audiovox Corporation

6.06

0.26

0.44

NA

(GTS)

Triple-S Management Corp.

9.43

0.27

0.82

NA

(AYR)

Aircastle Limited

8.28

1.43

0.61

5.21

(DFG)

Delphi Financial Group, Inc.

7.67

0.76

0.83

1.83

(FSIN)

Fushi Copperweld, Inc.

12.5

1.02

0.77

NA

(TWGP)

Tower Group, Inc.

12.48

0.49

0.84

3.5

(BBOX)

Black Box Corporation

10.03

0.46

0.66

0.99

(SNX

SYNNEX Corporation

7.78

0.11

0.94

NA

(TECD)

Tech Data Corporation

9.91

0.08

0.98

NA

(ASI)

American Safety Insurance Holdings,

7.96

0.79

0.65

NA

(GPRE)

Green Plains Renewable Energy Inc.

9.59

0.1

0.71

NA

(UNTD)

United Online, Inc.

8.79

0.52

0.99

7.58

(VSEC)

VSE Corporation

6.71

0.19

0.95

1.12

(LPNT)

LifePoint Hospitals, Inc.

12

0.52

0.95

NA

(VCBI)

Virginia Commerce Bancorp, Inc.

9.82

1.65

0.9

NA

(LCUT)

Lifetime Brands, Inc.

7.82

0.34

1.09

0.82

(NSIT)

Insight Enterprises, Inc.

7.98

0.13

1.21

NA

(FDEF)

First Defiance Financial

11.72

1.47

0.6

1.36

Questions Remaining

While we are able to create a trading strategy that has resulted in previous excess gain, we are left with some questions:

  • Why do small, value momentum stocks outperform? Is it because of higher risk with a 'risk premium' or is it because of market inefficiencies?

While we may choose to trade such a back-tested strategy in small value stocks with decent momentum, it is vital that we discern the reasons why these stocks outperform so that we can forecast whether this phenomenon will persist.

Disclosure: I have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

Source: 20 Small Value Stocks Linked To Market-Beating Gains