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SDS (Seductive Dividend Stocks)
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Sorry I hide my true identity but I'm a physicist/engineer, native contrarian and idea generator. I am an eclectic dividend investor with motto "In God We Trust, All Others Pay Cash" applied to companies I invest in. I like to read /and read a lot - did you look on my SA photo 8-)? /... More
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  • A Note About Smaller Risk Of Small Public Companies (15 Feb. 2012)  2 comments
    Feb 15, 2012 1:20 AM

    It is well documented that small public companies with capitalization well below average or median (small-cap stocks) and so-called value stocks with a high book-to-market ratio outperform the broad market. In order to describe stock returns within framework of traditional finance Fama and French published famous three-factor model in 1992. In this model they explained small-cap and value effects with two factors (one for size and one for value) additional to classical beta used in Capital Asset Pricing Model for which Sharpe, Markowitz and Merton Miller received the Nobel Prize in Economics. Being a student of a Nobel Price winner in Physics (sorry cannot disclose the name) I'd like to point a new (as far as I - an amateur investor know) aspect.

    I think that the bottom line of Fama-French paper important for this note is: SMALL CAP STOCKS OUTPERFORM MARKET BECAUSE THEY ARE MORE RISKY.

    Although the term risk is not well defined in finance at least volatility (which is often used as the risk proxy) of small-cap stocks is indeed higher than volatility of large cap stocks. Intuitively it should be so because less amount of money is needed to shift small-cap stock price to compare with stock of big company.

    But in my opinion there are two interrelated risk factors that are SMALLER for small public companies than for large one, because of the following factor.

    An annual financial report of a small company with often 1 line of business is usually simpler (and shorter) that the same report of a big company with several branches.

    Hence I can make 2 statements:

    Risk 1: Auditors make less mistakes approving annual financial report of a small company to compare with big company report. Therefore numbers are more trustable in a small company report than in a big company report.

    Risk 2: It is easy to comprehend an annual financial report of a small company than an annual financial report of a big company, so an investor (and/or an analyst) makes more explicable action with stock of small company to compare with stock of big company.

    Well, I don't think that my statements are bulletproof. My goal is rather to show that the term risk is not well defined in finance.

    Disclosure: I invest in some small-cap and large cap companies and receive their annual reports but not always read these reports. Most of my investment are in dividend stocks of small- middle- and large-cap companies and risk of this investment has almost nothing common with price volatility and Fama-French model.

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  • Larry Swedroe
    , contributor
    Comments (2407) | Send Message
     
    For those interested in academic papers that provide good, simple, logic explanations for the risks of investing in small and value stocks I suggest you begin with these. Hope you find them helpful

     

    1.Baruch Lev and Theodore Sougiannis, “Penetrating the Book-to-Market Black Box,” Journal of Business Finance and Accounting (April/May 1999).
    2.Robert F. Peterkort and James F. Neilsen, “Is the Book-to-Market Ratio a Measure of Risk?” Journal of Financial Research (Winter 2005).
    3.Maria Vassalou and Yuhang Xing, “Default Risk in Equity Returns,” Journal of Finance (April 2004).
    4.Xinting Fan and Ming Liu, “Understanding Size and the Book-to-Market Ratio: An Empirical Exploration of Berk’s Critique,” Journal of Financial Research (Winter 2005).
    5.Howard W. Chan and Robert W. Faff, “Asset Pricing and the Illiquidity Premium,” The Financial Review (November 2005).
    6.Charles Lee and Bhaskaran Swaminathan, “Price Momentum and Trading Volume,” Journal of Finance (October 2000).
    7.Ralitsa Petkova, “Do the Fama-French Factors Proxy for Innovations in Predictive Variables?” Journal of Finance (April 2006).
    8. Aydin Akgun and Rajna Gibson, “ Recovery Risk in Stock Returns,” Journal of Portfolio Management, Winter 2001.
    9. Gerald R. Jensen and Jeffrey M. Mercer, “Monetary Policy and the Cross-Section of Expected Returns,” Journal of Financial Research, Spring 2002.
    10.Gabriel Perez-Quiros and Allan Timmerman, “Firm Size and Cyclical Variations in Stock Returns,” July 1999.
    11.Lu Zhang, “The Value Premium.” January 2002, http://bit.ly/xyBA99
    12.Joao Gomes, Leonid Kogan, and Lu Zhang, “ Equilibrium Cross-Section of Returns, March 2001. http://bit.ly/wSkkQI~zhanglu/
    13. Moon K. Kim and David A Burnie, “The Firm Size Effect and the Economic Cycle,” Journal of Financial Research, Spring 2002.
    14.Nai-fu Chen and Feng Zhang, Journal of Business, “Risk and Return of Value Stocks,” October 1998.
    15. Clifford S. Asness, Tobias J. Moskowitz, and Lasse H. Pedersen∗Value and Momentum Everywhere, February 2009.
    16. Joachim Grammig, “Creative Destruction and Asset Prices,” March 2011.
    17. Jia Wang, Gulser Meric, Zugang Liu, and Ilhan Meric, “The Determinants of Stock Returns in the October 9, 2007-March 9, 2009 Bear Market,” The Journal of Investing (Fall 2011).

     

    BTW-being able to understand more easily a less complex company does not in any way make it a less risky investment. Remember YOU are not setting the price, but institutional investors who certainly have the skills to analyze the company's financials set the price as they do most of the trading.

     

    Also don't think that Risk 1 can be made as a statement, only a hypothesis, at best. Also remember that small companies often don't hire the top firms, so perhaps there is risk that they don't get the best auditors>

     

    Some simple risks stories for example, small companies have fewer sources of capital, they also tend to be the first to get cut off when liquidity crisis hit and banks cut back lending. They also tend to be less diversified businesses and have less depth of management, and so on. And of course their stocks are less liquid, making it more expensive to trade them, especially when liquidity dries up, and that alone makes them more risky and require a risk premium. Don't even need the rest of the logical stories.

     

    Best wishes
    Larry
    15 Feb 2012, 10:24 AM Reply Like
  • SDS (Seductive Dividend Sto...
    , contributor
    Comments (4012) | Send Message
     
    Author’s reply » Larry,

     

    Thank you for the list.

     

    I'd not agree with all your notes. My point was to show that risk is ill-defined term and in some aspects of common approach small-cap = big risk, large-cap = small risk are questionable.

     

    SDS, a nano-cap investor without competition from institutional investors 8-).
    15 Feb 2012, 11:13 PM Reply Like
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