5 Ways To Beat The Market: Size Update For 2019

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About: iShares Core S&P Small-Cap ETF (IJR), Includes: IWM, SMDV, SPY, VBR, XSLV
by: Ploutos
Summary

In an ongoing series of articles, I have highlighted five buy-and-hold strategies that have historically outperformed the S&P 500.

Stock ownership by U.S. households is low and falling, even as the barriers to entering the market have been reduced. Improved financial literacy is a motivator for my authorship.

Investors should understand simple and easy to implement strategies that have been shown to outperform the market over long time intervals.

The first of five strategies I will revisit in this series of articles is the "size factor" that has seen small caps outperform large caps over time.

This article discusses the long-run outperformance of small-caps, factor tilts that have further boosted performance, relative returns in 2018, and an outlook for 2019.

Do stocks with smaller market capitalizations tend to outperform larger companies? While the megacaps like Apple and Amazon tend to grab the headlines, the choice between small-cap stocks and large cap stocks is one that most stock investors make. Many 401k options offer a small-cap sleeve. The minority of Americans who own investments outside of their retirement accounts can also drive asset allocation decisions between capitalization levels.

In my ongoing series on "5 Ways to Beat the Market", I have suggested that size - along with value, low volatility, dividend growth, and equal-weighting - are simply and easy-to-implement factor tilts or alternative weighting schema away from traditional capitalization-weighting that can boost returns for the average investors.

Size might be the most controversial of these five factor tilts. In this article, I will give long-run evidence on this factor, describe complementary tilts that can enhance risk-adjusted returns, and describe the size factors performance in 2018 and outlook for future years.

Let's start with the long-run evidence. To do that we take returns from the data library of Dartmouth professor Kenneth French. Along with Chicago professor and Nobel Laureate Eugene Fama, the pair created the Fama-French Three-Factor Model, which posited that market returns could be better described by including two factors - size and value - that had delivered historical outperformance. In a dataset dating back more than ninety years, I have graphed the historical total returns of deciles of the U.S. stock market divided by capitalization-level.

Performance of U.S. stocks by capitalization level That is pretty compelling long-run evidence. It is clear that size and realized returns have been negatively correlated. This long-run outperformance by small-cap stocks was first recorded by Rolf Banz in 1981, showing that small NYSE firms had produced significantly higher risk-adjusted returns than their larger brethren over a period between 1936 and 1977. This is where the discussion of size gets more controversial.

If you shrink the data sample period since 1981, when the evidence on size became more mainstream in the academic literature, the relationship appears to reverse.

Performance of U.S. stocks by capitalization level since 1981 In spite of this more recent contradictory evidence, the long-run outperformance of the size factor makes intuitive sense to me. Some small companies turn into big companies, generating high returns along the way. Some big companies turn into small companies as their company-specific advantage is competed away or their industry falls out of favor.

What is also clear is that small-cap stocks have higher variability. Below I have taken the same ultra-long time series from Kenneth French and calculated the annualized standard deviation of monthly returns. Smaller stocks have higher return variability.

Risk of U.S. stocks by size level Small-cap stocks have runway to grow into larger companies, but there is also a higher degree that they will fail given their smaller scale. We need a sort to divide the good companies that will manage to generate compounding returns over time from the bad companies that will go out of business. We also need a way to make sure that we are paying the right price for small-cap stocks. Tilts towards low volatility and dividend growth should be effective screens for companies that can stay in business and compound. Value should be a good screen to ensure you are paying a fair price.

Below I have graphed the Russell 2000 (IWM), the S&P 500 (SPY), the S&P 600 Low Volatility Index (XSLV), the S&P 600 Value (VBR), and the Russell 2000 Dividend Growth Index (SMDV) for the longest co-terminus dataset I have for the five indices.

Performance of size factor tilts Source: Bloomberg

It is easy to see why there might be some small-cap skeptics out there. The Russell 2000, the most popular small-cap benchmark, has failed to best the S&P 500 over the past two-plus decades. Look what happens when you add a quality tilt though - the S&P 600 Low Volatility and the Russell 2000 Dividend Growers - generated roughly 12% annualized returns. Small-cap value also meaningfully outperformed the broad small-cap and large-cap indices. Over the past two-plus decades, the size premia did not go away, you just needed to marry it to other factor to deliver outperformance.

Over long-time intervals, these small-cap strategies have delivered really strong returns. I have made some past articles on these topics "Author's Picks", so readers can see the long-run dataset outside the paywall.

  • In Small Caps And Low Volatility: A Long-Run Study, I demonstrated that when U.S. stocks were subdivided into quintiles based on capitalization and volatility that the small-cap low volatility stocks generated tremendous outperformance in a period dating more than fifty years.
  • In a Strategy That Sells Itself, I illustrated that even in the worst ten-year periods for the strategy that small-cap low volatility stocks still generated solid 6-7% total returns.
  • In Small Cap Dividend Aristocrats, I illustrated that an equal-weight portfolio of small-cap stocks that have paid increasing levels of dividends for at least ten years has generated above market returns with below market risk.
  • In Looking At Small-Cap Value, I illustrated that when U.S. stocks were sub-divided into portfolios based on capitalization and market-to-book ratios that small-cap value delivered average annual returns 4.7% above the broader market over a dataset stretching back to 1926.

In the first half of 2018, these strategies continued to deliver strong outperformance, but small-cap stocks meaningfully underperformed in the back half of the year.

Performance of size factor in 2018 By late August, the S&P 600 (IJR) was up almost 19% on the year, strongly outpacing the solid returns of the large-cap benchmark. By the end of the year, the Russell 2000 was down 11% and the S&P 600 was down 8.5%. The S&P 600 Value fared even worse down 12.6%. Low volatility small-caps -5.1% also underperformed. Only the Russell 2000 Dividend Growers managed to post market-beating returns at -0.3%.

I believe in the long-run outperformance of size. I think it can be furthered by tilts towards low volatility, dividend growth, and value. The underperformance of the size factor in the back half of 2018 makes valuations more compelling. A recent report by Barclays showed that the Russell 2000 looked as cheap to the Russell 1000 on a price-to-sales and price-to-cash flow basis as any time since the early 2000s. While I believe that there are structural reasons for small-caps to outperform over business cycles, I also believe there might be tactical reasons why small-cap stocks outperform in 2019 given my more constructive view for equities and cheapening valuations for small-caps beaten up late in 2018.

For long-term investors with a buy-and-hold approach, the size factor has generated long-run structural alpha over the recorded history of modern finance. Combining the size factor with low volatility, dividend growth, and value has enhanced long-run outperformance even further. Small-cap focused trades underperformed in the back half of 2018, but valuations look increasingly compelling.

Over the next several days, I will be publishing updated results for four additional proven buy-and-hold strategies that can be replicated through low-cost indices. These articles will demonstrate their long-run performance and offer an outlook for 2019.

Disclaimer: My articles may contain statements and projections that are forward-looking in nature, and therefore inherently subject to numerous risks, uncertainties and assumptions. While my articles focus on generating long-term risk-adjusted returns, investment decisions necessarily involve the risk of loss of principal. Individual investor circumstances vary significantly, and information gleaned from my articles should be applied to your own unique investment situation, objectives, risk tolerance, and investment horizon.

Disclosure: I am/we are long IJR,XSLV,SMDV,VBR,SPY. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.