Do Good Things Still Come in Small-Cap Packages?

Over the past several years, small-cap fund performance has come under scrutiny and the credo of the "small-cap premium" has all but evaporated. The notion, that an investor should earn a premium for investing in smaller companies due to the increased risk associated with them, was not considered a violation of market efficiency but rather a compensation to the investor for investing in companies with vulnerabilities such as:

  • Limited financial resources
  • Weaker competitive advantage
  • Lower profitability
  • Increased volatility
  • Illiquidity (due to thinner trading)
  • Reduced analyst coverage (which may increase the risk of mispricing)
  • The concept of the small-cap premium was first uncovered by a study (conducted in 1981) that found these stocks exhibiting higher risk-adjusted returns than large caps (by 3.1% for the period between 1927 and 1981).

    Over the past few years, however, the trend has reversed, raising a lot of questions in the investment community and precipitating a second study authored by a team of gurus at the U.S. hedge fund AQR (Cliff Asness, Andrea Frazzini, Ronen Israel, Toby Moskowitz and Lasse Pederesen).

    The paper, released early last year (cleverly entitled, "Size Matters if You Control Your Junk"), resurrects the idea of the small cap premium by introducing the quality factor. The study set out to determine whether the small cap premium does in fact exist once the quality of the underlying business is considered. This factor was measured objectively based on metrics such as profitability, profit growth, earnings stability and high dividend payouts. Those at the opposite end of this spectrum of criteria were considered "junk" stocks. The study found that, when the high quality small caps were culled out and analyzed, they not only outperformed large caps by a significant margin but they did so consistently across time, industries and markets. The conclusion: the low-quality small caps had essentially been dragging down the performance of the group as a whole.

    It's important to note that higher-quality small caps should not be confused with "value" stocks. By definition, value stocks are those trading at low valuations compared to fundamentals such as book value, earnings, or sales. According to Frazzini, the AQR study (which defined value stocks based on book values) found that such stocks are more closely related to the junk end of the spectrum because in many instances they deserve to be cheap. However, among stocks of similar quality, the most favorable are those with the lowest P/B ratios.

    The findings of the AQR study also present a bit of a quandary: If the risker small-cap stocks are the culprits for lower returns, does this refute the fundamental tenet that more risk earns higher rewards for the investor? It begs the question as to whether size premium might be due in part to market mispricing and whether illiquidity is indeed a valid explanation. So, in the end, the study findings raise additional questions that may be fodder for future research.

    I choose stocks using a number of models based on the approaches of Warren Buffett, Peter Lynch, and other Wall Street greats. These approaches use a variety of quality metrics to weed out junk stocks, and often they find their best picks in the small-cap space. Here are five small-cap stocks that my Guru Stock Screener says are worth a look:

    Innospec Inc. ( IOSP ) develops, manufactures and supplies fuel additives, oilfield chemicals, personal care and fragrance ingredients and other specialty chemicals (market cap of $1.09 billion). According to our Benjamin Graham-based "Value Investor" strategy, IOSP earns a perfect score based on healthy liquidity (current ratio of 2.94), low leverage (debt is only 52% of net current assets) and exceptional earnings-per-share growth (more than quadrupled over the past 9 years). Our Lynch model likes the yield-adjusted price-earnings-growth ratio (P/E/G) of 0.47, which is in the best case category (below 0.5) under this model.

    Marcus & Millichap Inc. ( MMI ) is a brokerage firm specializing in commercial real estate sales, financing, research and advisory services (market cap of $934 million). The company has over 1,600 sales and financing professionals in over 80 offices in the U.S. and Canada. According to our Kenneth Fisher strategy, MMI gets high marks for its inflation-adjusted long-term earnings-per-share growth of 38.36%, more than double the minimum of 15% required to pass this screen. The P/E/G of 0.35 and low leverage also satisfy our Lynch model.

    LGI Homes Inc. ( LGIH ) is engaged in the design, construction, marketing and sale of new homes in Texas, Florida and the southwest and southeast regions of the U.S. as well as in Colorado and Washington (market cap of $679 million). Our Validea "Momentum Investor" model gives LGIH a perfect score based on its stellar quarterly earnings-per-share growth (compared to the same quarter last year) of 72.73%, well above the model's minimum requirement of 18%. Earnings-per-share have increased consistently for the last five years, and return-on-equity of 25.0% well exceeds the minimum requirement of 17%. Our James O'Shaughnessy screen gives a thumbs up to LGIH's price-to-sales ratio of 1.01 (versus 1.5 maximum) which, coupled with consistent EPS growth, suggests that this growth stocks is still cheap to buy.

    Fossil Group Inc. ( FOSL ) is a design, marketing and distribution company that specializes in consumer fashion accessories and operates in the Americas, Europe and Asia (market cap of $1.4 billion). Our Joel Greenblatt-based stock screening model gives FOSL high marks for its 32.84% earnings yield and return-on-capital of 45.61%. Our Graham strategy favors the company's healthy liquidity (current ratio of 3.60) and low long-term debt to net current assets (0.83). Over the last ten years, this company has seen earnings-per-share more than triple, and its price-to-book is modest at 1.44.

    Sanderson Farms, Inc. ( SAFM ) is engaged in the production, marketing and distribution of fresh and frozen chicken and prepared chicken items (market cap of $2.0 billion). The company's moderate price-to-sales ratio (0.73) and long term EPS growth of 31.72% (more than twice the required level) are both pluses under our Fisher model. Three-year net profit margin is healthy at 7.18% (versus a 5% minimum requirement). Our Lynch screen, which considers SAFM a "Fast Grower", favors the P/E/G ratio of 0.43 and the company's extremely low leverage.

    I'm long IOSP, MMI, LGIH and FOSL and SAFM

    The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

    The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.

    More Related Articles

    Info icon

    This data feed is not available at this time.

    Sign up for Smart Investing to get the latest news, strategies and tips to help you invest smarter.