Leveraged Small Value Equities
Stanford University, Graduate School of Business, Students
University of Chicago – Booth School of Business
The size premium and value premium are well documented in academic studies. We contribute to this literature by finding that leverage – as defined by long term debt divided by enterprise value – enhances the average returns of a small-value investment strategy. At the company level, our results indicate that there is a positive interaction between leverage and value. We test a variety of quality and technical factors to develop a theory of what works in leveraged small-value equity investing. We develop a ranking system for creating annual portfolios of leveraged small-value stocks in the United States. This ranking system prioritizes smaller, cheaper and more leveraged stocks that are already paying down debt and exhibit improving asset turnover. Annual portfolios of the top 25 stocks in this ranking system have a 25.1% average annual return between 1965 and 2013. At a standard deviation of 39.4%, the Sharpe Ratio of these annual portfolio returns is 0.51. These portfolios have a CAPM alpha of 9.6% and a CAPM beta of 1.66. The average risk-adjusted return of these portfolios is 13.1% per year after controlling for the 3 Fama-French factors, momentum, and liquidity. In addition to providing a novel investment strategy, we believe that our findings have implications for the leveraged buyout industry — which follows an analogous investment approach in the private markets — as well as for public market value investors who have traditionally eschewed leverage.
Leveraged Small Value Equities – Introduction
Financial leverage, as measured by long-term debt divided by enterprise value (EV), improves the returns of a small-value investment strategy. Practitioners in the leveraged-buyout industry have widely understood the key elements of this “small-value on steroids” strategy, adding leverage to small-value companies in the private markets to great success.1 Our paper is the first to test these variables in the public equity markets and provides the first in-depth quantitative exploration of how to successfully invest in leveraged small-value stocks in the public equity markets.
Our study is based on an analysis of U.S. stocks between January 1964 and December 2014, which were compiled from the Center for Research in Security Prices (CRSP) database. Specifically, we analyze the returns of annual portfolios that are drawn from a target universe of stocks that are cheap (below 25th percentile of EBITDA/EV), small (25th to 75th percentile of market capitalization) and leveraged—with above median Long Term Debt/EV relative to all NYSE/AMEX/NASDAQ stocks in a given year.
We find that that there are five factors that are statistically significant in predicting returns within this universe. In order of significance, those factors are: debt pay-down (?? ???????? ??1 < ?? ???????? ??2), LT Debt/EV, improving asset turnover , market capitalization, and EBITDA/EV. We provide a theoretical explanation for this observed behavior, focused on the idea that the excess returns from this strategy come primarily through deleveraging, a virtuous cycle of reduced interest payments, improved financial stability, and value accrual for equity investors. Free cash flow yields and business quality metrics help best identify the companies that are most capable of paying back their debt.
We also find some evidence for short term reversals in one-year price performance; stocks that had below-median returns in the prior year tend to outperform the above-median-return stocks from that period in the subsequent year. This relationship is stronger among the below-median-return stocks that had low share turnover in the prior year. Our observation of short term reversals among low share turnover, “past loser” stocks is consistent with the research published by Lee and Swaminathan (2000), who find that firms with low (high) past turnover ratios exhibit many value (glamour) characteristics and earn higher (lower) future returns.
We develop a ranking system based on these factors that produces a robust and novel investment strategy. This ranking system distinguishes companies that generate attractive returns from those that underperform. The Top 25 Portfolios’ annual equal-weighted returns exceed the market by 11.7 percentage points on average. The annual equal-weighted returns of the Top 50 Portfolios exceed the market by 9.2 percentage points on average. Similarly, the Q1 Portfolios’ annual equal-weighted returns exceed the market by 9.1 percentage points on average. All three of these results are statistically significant at t=4.65, t=4.90, and t=5.65 respectively. There is no evidence that the Q2 Portfolios or the Q3 Portfolios generate average returns that are different from the market. The Q4 Portfolios underperform the universe by a statistically significant 3.6 percentage points per year on average. Our ranking system is robust in terms of identifying winners and losers in the universe of leveraged small-value stocks. The ranking system assigns better ranks to stocks that have higher expected returns, and it assigns worse ranks to the least attractive stocks that have lower expected returns.
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