Merrill Lynch's Strategies for a Volatile Small Cap Market

In the volatile “wild west” world of small-cap stocks, bigger small cap companies tend to do better than the smaller small caps, and a high turnover, portfolio management strategy tends to outpace a less active approach, according to a report by Merrill Lynch analyst Steven DeSanctis.

Mr. DeSanctis said:

It has been a wild market thus far in 2008, with plenty of twists and turns.

This has be the most volatility anyone has seen since we traced the data back to 1993 and may rival the swings back in the fall of 1987.

Not only has the volatility affected large cap stocks - “When has an investor seen a large-cap stock rise and fall by 20% or more in any given day?, Mr. Sanctis asks in his report - but small cap investors are “having a very difficult time figuring out which way the market, sectors, and stocks are heading.”

 

This is seen in the statistics on fund manager performances compiled by Merrill. Mr. DeSanctis noted that less than 7% of small-cap growth and value managers beat their bench marks in July, while a “less than impressive” 11% of core funds did so. As for the year-do-date totals, he said just 13.5% of growth funds are ahead of the game, while less than 30% of core funds and 37.7% of value funds are “topping their bogeys.”

 

Mr. DeSanctis argues in his report that active managers should raise their level of turnover to take advantage of the swings in stock prices.

Our data supports this thesis, as in the core and growth categories we saw managers tend to have higher levels of turnover and better alphas when volatility was on the rise.

Given that “volatility is here to stay for the near future,” Mr. DeSanctis also looked at what strategies worked and did not work in this volatile investing environment. He compared small cap stocks to their large-cap counterparts, as well as investing strategies, then looked inside the small-cap world itself for which companies did best when it came to quality and earnings growth.

What he found is that, during the five periods of high volatility since 1993 that he looked at, large cap stocks averaged a gain of 11%, based on the Russell 1000 Index (IWB), while the small caps gained 7.7%. That placed the average excess return between the small and large caps at minus 1.9%.

As well, in the past five periods of volatility reviewed, a “value” strategy appears to have beaten out “growth”, he said, with the Russell 2000 Value Index (IWN) gaining an average of 11.2% versus just a rise of 3.9% for the Russell 2000 Growth Index (IWO). However, things are a bit different in this current period of volatility, he said, noting that he is finding growth investing “much more affordable than value” and earnings have held up much better than in value. “In fact, value’s earnings have been down year-over-year for almost two straight years.”

Inside the small cap world, the larger companies tended to outperform by almost 2% over the five time periods studied. He also found that “higher quality” stocks tended to beat “lower quality” by an average of 6.5% “based on the performance of earners versus non-earners” Finally, Mr. DeSanctis noted his review showed slower growth stocks tended to outpace faster growth stocks by an average of 6%.

Mr. DeSanctis also looked at what quantitative factors worked best in assessing the small cap universe in volatile times. He determined that Enterprise Value to Earnings Before Interest, Taxation, Depreciation and Amortization [EV to EBITDA] tended to work the best, and did a better job than looking at free cash flow yield. The best fundamental indicator was Return on Invested Capital [ROIC] while momentum indicators such as earnings stability, earnings surprise and book-to-price were weaker compared to looking at relative price strength.