Beat The Market With Small Companies But You Have To Do This by Tim du Toit, Quant Investing

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Can you beat the market by investing in small companies?

This is a simple question I am sure you have also asked yourself but not something that can be answered as easy as I thought.

Past research not encouraging

Past research on small company returns, which I am sure you have also seen, found that:

  • They were mainly generated in January
  • They varied significantly over different time periods
  • The outperformance declined substantially from the early 1980’s when the first research papers appeared saying that small companies outperform.
  • The best performing companies were too small to buy (less than $5 million in market value)
  • Small company outperformance could not be found internationally
  • The best performance was concentrated in a few illiquid companies

I'm sure these findings did not give you any reason to think that you can beat the market by buying small companies. Or that it’s even worth investigating further.

However a recent research paper I studied has changed my thinking and I am sure will change yours as well.

(Be sure to read to the end of the article where I show you exactly how to find the right companies)

But it is all not true

Small CompaniesAll the above ideas on investing in small companies were found not true by a very extensive 59 page research paper published in January 2015 called Size Matters, If You Control for Junk.

The paper was written by five researchers all linked to the respected fund management company AQR Capital Management.

First get rid of junk companies

The paper found that small companies generate substantially higher returns than large companies and the market BUT (very important) you must only invest in quality small companies.

They also found that:

  • You do not have to invest in the smallest companies to get these returns,
  • Small quality companies outperform the market and large companies over all time periods,
  • Quality small companies also outperform the market and large companies internationally and
  • You do not have to invest in small illiquid companies to get these higher returns.

What you have to look for

This all sounds very good I'm sure you also thinking.

But before we start buying let's find out exactly what the researchers tested and what they did to find quality small companies.

What they tested

Data used – 55 and 29 years

In the USA the researchers used over 55 years of data (July 1926 to December 2012).

Internationally the researchers tested their ideas in 23 countries using 29 years’ worth of data (January 1983 to December 2012).

How quality minus junk was tested

The researchers separated companies between junk and quality as described in the 2013 research paper Quality Minus Junk:

  • Profitability - Calculated as profitability over book value,
  • Growth – Calculated as profit growth over the past five-years,
  • Safety - Defined as lower than market beta and volatility and fundamental-based measures of safety such as low leverage, low volatility of profitability, and low credit risk,
  • Pay-out - Measured as the part of profits paid out to shareholders. This is an indicator of shareholder friendliness as it lowers the conflict of interest between shareholders and management as it decreases free cash flow. A higher pay-out is more positive as long as it does not lower future profitability.

These portfolios were formed and tested

All the companies back test database were ranked by size (large and small companies) and quality (good quality, middle quality, junk quality).

They then formed six portfolios to track - good quality, middle quality, junk quality large companies and good quality, middle quality, junk quality small companies.

To calculate performance they went long the two quality portfolios (large and small quality) and shorted the two junk portfolios (large and small company junk).

What they found

  1. The Size effect is not large – until you look at quality and junk

Just investing in small companies would not have helped you outperform the market as the return from investing in small companies minus the return from investing in large companies on average did about 0.12% per month better than the market which is not much different than zero.

But if you bought quality small companies and shorted junk small companies the researchers found it increased returns substantially.

If you use this strategy it would have increased your monthly market outperformance to 0.49% (just under 6% per year), a significant improvement.

Small Companies

Source: Size Matters, If You Control for Junk.

This may not sound like much until you think that this was achieved over a 55 year period in the USA. The outperformance is HUGE!

They also tested this across 30 different industries and quality small companies minus junk small companies did substantially better than a small minus big company strategy.

Small Companies

Source: Size Matters, If You Control for Junk.

  1. Does the performance differ over time?

It is a well-known fact that small companies did not do well in the 19 year period from 1980 until 1999.

However when the researchers tested the small company quality and junk strategy (long and short) this proved to be no longer true.

The strategy improved the return of small companies to the same level in the 22 year period when small company investing did really well from July 1957 to December 1979.

  1. Is the small company quality minus junk outperformance mainly due to extremely small companies?

The researchers found that this is true if you just look for cheap small companies.

But when they only looked at a strategy of buying quality minus junk companies they found that the performance increases steadily as you moved from large to small companies with no extreme movements by very small companies for example.

Small Companies

Source: Size Matters, If You Control for Junk.

  1. What about size measures not linked to share price?

To move away from market value as the only definition of company size the researchers also looked at the performance of small companies as defined by:

  • Total assets
  • Equity
  • Sales
  • Property, plant and Equipment (PP&E)
  • Number of employees

The results were the same as other factors the researchers looked at.

If they did not look at quality, and looked only at the size factors above, there was no indication that small companies performed better than large companies.

But as soon as they looked only at quality companies small companies based on all the above definitions of size, did better than large companies.

  1. Does buying quality small companies world-wide work?

The researchers tested their strategy of investing in quality small companies and shorting junk small companies across 24 countries.

The strategy beat the same strategy invested in large companies in 23 of the 24 countries tested. Only in Ireland did it perform the same.

The researchers also tested the above mentioned other measures of company size and found that in all cases did quality small company strategy do a lot better than large companies.

Small Companies

Source: Size Matters, If You Control for Junk.

Research conclusion

In the conclusion of all their research the researchers simply said:

Size matters, much

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