Small capitalization stocks are an interesting breed. This portion of the markets contains thousands of names that are unloved and unappreciated. The space is a treasure trove for long-term and disciplined individual investors. In a series of posts, I will explore some nuances of the space that make it so incredibly appealing to the discerning investor. But, buyer beware because there is a lot of junk in small cap.
Dozens of studies have demonstrated that investors myopically focus on bottom line earnings. I'll add to that and say that the behavioral bias has morphed. Whereas the bias used to focus at the individual stock level, it is now the case at the index level. In a decidedly opposite twist of the classic cliche, investors can't see the trees for the forest. Why? The move to passive indexing has obfiscated the most basic principal of capitalism. Money should flow to the best opportunities for investor return.
How each of us defines, "opportunity" is subjective. Opportunity can be defined as a stock trading below book value, a biotech firm about to receive FDA approval, and everything in between. In the upper realm of high finance, this concept of opportunity is referred to as "intrinsic value". The avenue by which the market realizes intrinsic value is called "price discovery." Passive indexing is nothing more than allocating to the market, pro-rata based on a company's existing size. It, therefore, negates price discovery. Indexing is decidedly investing in mediocrity. Indexes are, after all, capitalization weighted AVERAGES by definition and construction.
Most investors may be surprised by the wide dispersion in returns of index constituents that exists. We looked at small capitalization stocks back to 1964 and found the group of stocks, weighted equally, returned 12.3% annualized over the 50+ year period. That roughly equates to the return of the Russell 2000® Index, though the index did not start until 1979. Now it gets interesting. We cheated by ranking stocks based on their future return over the next 12 months and put them into five buckets (quintiles). We then measured the average 12 month return from 1964-2015. Keep in mind, these exact same stocks generated the 12.3% annualized return I referenced earlier. If you were an investor with perfect foresight and you could invest in the bucket of stocks with the best forward 12 month return, your portfolio would return 65.2% per year for over 50 years. On the flip side of the equation, if you had some sadomasochistic tendencies and invested in the bucket of stocks you knew would perform the worst over the next 12 months, your portfolio would have returned -50.8% over the next 50 years. Again, these are the exact sames stocks that when combined in a weighted-average index return, generate 12.3% per year.
With an index investment, like the Russell 2000®, you get the best AND the worst. Our task as investors is to identify characteristics of successful stocks and orient portfolios towards the best performers, while eschewing the worst. Over the next several posts, I'll dive into the details of this unique playground for discerning investors.