Smallcaps With Attractive Price-to-Book Ratios

by: Mark Hines

I've spent much of the last several weeks reading a variety of academic papers on quantitative models from various Finance and Economics Journals (click here for some of my favorites). I'm generally suspicious of the Real World applications of such academic research, so I also back-tested some of these factor models using current Real World data (click here for data, regression results, and a graph of the regression results). Much to my surprise, the factor models actually did a very good job of outperforming the market!

The two quantitative model factors I tested are book to market value ratios and small market capitalization. The reason I chose these two factors is because there is much research suggesting they capture the explanatory power of most other quantitative factors. Anyway, the regression results suggest it is possible to consistently outperform the market over time by simply constructing portfolios with high book to market values and small market capitalizations. If you don't want to take my word for it, then check out Dimensional Fund Advisors and LSV Asset Management. These two firms have tens of billions of dollars under management because they have been consistently outperforming the markets by constructing portfolios with low price to book-value ratios and small market capitalizations.

Despite the outstanding factor model results, I would feel remiss if I didn't point out a few very important facts. First, many academics will lead you to believe that factor models are the only way to outperform the market. However, anyone with a little bit of statistics background (and some common sense) knows the factor models miss out on many outstanding investment opportunities because of the broad-based assumptions they make. Specific examples include multivariate normal distributions, stationary regression coefficients over time, pitiful attempts at intertemporal choices, and a complete disregard for the idiosyncratic risks that make Real World investors like Warren Buffett so great!

Overall, there is more than one way to skin a cat. Academic factor models and real world stock pickers are both extremely viable means to succeed in the stock market. If you tend to prefer real world stock pickers, then check out some of the VesTopia Investment Directors to help you generate ideas. And if you tend to prefer the quant models, that's okay too.

In the meantime, here is a list of 18 stocks (two from each broad market sector) that screen well on book to market value and on small market capitalization. I plan to check on the performance of this portfolio every month or so, and I'll be sure to share the performance results with my readers.

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