Size Matters: How Market Structure Favors Small Funds
Since Eugene Fama revolutionized the field of quantitative finance by introducing the size and value factors to securities pricing models, few debates have occupied the minds of finance academics and practitioners as much as the existence of a size premium.
Academics at fund manager AQR sparked the most recent round in this age-old debate by releasing a paper arguing that there is “no evidence of a pure size effect” (emphasis added).
But do smaller companies provide excess returns (or excess risk-adjusted returns) over the long haul? Broadly speaking, does size matter?
We believe that the answer is “it depends” for individual stocks but “yes” for strategies based on selecting individual stocks. The simple reason for this is that there are far more small stocks than large stocks and also far greater dispersion on key variables (i.e., if you’re looking for cheap stocks, there will be a far higher absolute number of cheap small stocks than cheap large stocks, and the 10th percentile of the cheap small stocks will be far cheaper than the 10th percentile of the cheap large stocks).
Given that most investors’ primary concern is how to identify strategies that have a high probability of significantly outperforming the broader market, we would argue that the importance of size cannot be understated. But this is not a story most fund managers are willing to tell, because this story suggests that the ability to generate alpha is negatively correlated with the assets under management in a strategy.
In this three-part series, we’ll start with an examination of market structure in the two largest investible stock universes outside of the US with rigorous financial reporting standards (Part 1: Japan; Part 2: Europe), and finish with a review of the related literature (Part 3). We warn you that once you see some of this data, you’ll never be able to look at a multi-billion dollar active public equity fund in the same way…..
Findings from Japan:
Knowledge of terrain is crucial for any strategic decision making. In public equity strategies, this terrain can be thought of as the total universe of investible stocks along with their most strategically relevant attributes for market participants. Below we have charted the bird’s eye view of all listed public stocks in Japan above $50mm in market capitalization sorted by size.
Figure 1: Distribution of Japanese Public Equities by Market Capitalization*
What’s striking about this market environment is how many small companies there are relative to large companies. If one were running an investment strategy in this environment with a rule that constrained the strategy to only stocks above $2bn in market cap, one would be passing over 85% of the potential targets in the environment! If the rule were “only stocks over $500mm”, one would still be passing over 2/3 of investable opportunities.
While theoretically supportive of the hypothesis that size matters, the disproportionate selection choice in the small-cap world is not by itself proof that size = excess returns. We would need some evidence that the broader selection characteristic afforded by access to small caps is related to factors that reliably predict excess returns.
One of the most robust and reliable factors for predicting excess returns over the long haul is value. Below are the returns by decile of all stocks in the same Japanese market sorted each year by their valuation multiples from most expensive down to least expensive. On the left we have included the returns data for the entire millennium as well as the returns over the last five years, during a strong growth rally. On the right we have included the average multiple over the entire period to give you some idea of how cheap/expensive these stocks were in absolute terms.
Figure 2: Returns by Decile of Valuation Multiple (left) and Multiple Spreads (right)*
You will note that regardless of size, the cheapest stocks in the market have dramatically outperformed the most expensive. Even during the last five year’s growth rally, the cheapest stocks still seem to provide some excess returns. The data suggests that if you built portfolios at less than 1x book value, 6x EBITDA, or with a 20%+ EBITDA yield, you would have done quite well.
The next logical question is: are the cheapest stocks easier to access in the small-cap universe? Yes. Below are the valuation spreads over time within the ~85% of listed companies that are under $2bn of market capitalization and the ~15% of listed companies that are over $2bn of market capitalization.
Figure 3: Valuation Multiple Spreads for Small Caps (left) and Large Caps (right)*
Smaller companies were cheaper in almost every year we measured. However, what’s even more interesting from a portfolio construction standpoint is that if one wanted to build a portfolio below 5x EBITDA, one would have had a hard time finding very many companies at all in the large-cap space (the 90th percentile among large caps was 5.3x EBITDA last summer). In the much more numerous small-cap universe, more than 1 in 4 companies meet that criterion. The valuation spreads between the most expensive and least expensive companies in the small-cap space are much wider.
Figure 4: Valuation Spreads over Time (June of Each Year)*
Perhaps there is some common characteristic of larger companies that makes them more attractive than smaller companies and justifies these valuation spreads. Perhaps they will grow more. To test this, we decided to survey the CEOs and CFOs of all listed companies in Japan and ask if they agreed. (In Japan, essentially all publicly listed companies have been required to publish annual revenue and earnings guidance estimates for the last 10 years.)
It turns out, the Japanese CEOs and CFOs themselves do not seem to agree with this hypothesis. We found no evidence of excess growth projection for revenue or earning over the last 10 years from the average large-cap CEO vs. the average small-cap CEO. In fact, in 2018, the average company above $10bn in market cap forecasted 5% revenue growth and 3% earnings growth while the average company below $10bn forecasted ~6.5% revenue growth and ~15% earnings growth.
Perhaps the institutions and buyers behind the fund flows supporting the higher valuation multiples of larger stocks can forecast the future financials of the underlying companies better than the Japanese CEOs and CFOs of the companies in question. However, a far simpler explanation is looking more and more plausible: the relative valuations are unjustified by fundamentals and fundamental expectations.
However, none of this theory, as simple as it sounds, matters if we can’t show that a strategy to exploit the unique quantitative characteristics of small-cap companies would have worked. Below are the results of three simple strategies backtested since 2000 at different portfolio concentrations. This is not a backtest of Verdad's strategy. We simply sorted all Japanese stocks by their cheapness (EBITDA multiple and price-to-book value) for the last ~20 years in each strategy. The only difference between the three strategies is that we increased the minimum average daily trading volume (a proxy for size) of the companies that were included in the universe of investible stocks. Think all-caps ($100k min volume), medium and large-caps (>$500k), and large-cap only (>$1mm) strategies.
Figure 5: Deep Value Strategy Results by Concentration and Size Constraint (2000–2018)**
As you can see, there is a direct trade-off between both absolute and risk-adjusted returns (left) and strategy capacity, or how much money you could reasonably put to work while achieving these results (right). This suggest that if there are excess returns anywhere in the market, those returns are in precisely the stocks that are on the verge of being inaccessible to most fund managers (and ETF products) seeking to run higher amounts of assets under management. Whether one waters down a powerful ranking system by including too many stocks, or stays concentrated with just a few higher-volume names, there is no way out of the performance degradation to the strategies. Markets appear to be robustly efficient on nearly every metric except the prohibitively high-cost business decision of most investment funds to reduce capacity.
To us, this structural hypothesis is a far more intuitively and empirically sound explanation of the nature of excess returns in smaller companies. What’s more, this hypothesis offers a pretty good explanation of what the real costs of such a strategy are for relevant market participants, rather than the “free-lunch” premium explanation of equity returns we find in the 85% of published quant literature that doesn’t replicate when you exclude small caps.
However, we can’t be too confident until we see it in a separate independent environment. As George W. Bush once eloquently said, “There's an old saying in Tennessee—I know it's in Texas, probably in Tennessee—that says, fool me once, shame on—shame on you. Fool me—you can't get fooled again.” Next week we’ll take a look at how the same structural and size dynamics play out in Europe.
Notes:
* Source: Capital IQ. All publicly listed Japanese companies on the Tokyo Stock Exchange and JASDAQ above $50mm in market cap each June. Excludes Banks, REITS, and Capital Markets Securities.
** Source: Capital IQ. Portfolios rebalanced each June from 2000 to 2017 based on trailing TEV/EBITDA and price-to-book weights only for all publicly listed Japanese stocks above $50mm in market cap. “~Capacity” estimated as 5x the average daily volume of the bottom quartile of volume of the equal-weighted portfolio. Total returns indicated are in Yen. The MSCI Japan Small Value Index represents ~500 stocks on the Tokyo Stock Exchange.