Small Cap and Value Stocks - YouTube

- I owe all of you an apology.

This is my 50th video and in all of our time together

there is something that I have never told you.

I have concluded many of my videos with some variation

of you are probably better off

in low cost market cap weighted index funds,

which is a statement that I believe.

What I have not told you

and the reason that I think I owe you an apology,

is that I do not invest my own money

in market cap weighted index funds.

I'm Ben Felix, Portfolio Manager at PWL Capital.

In this episode of Common Sense Investing,

I'm going to remind you that there is more

to sensible investing than market cap weighted index funds.

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Before anyone gets upset, don't worry,

I do invest in a portfolio of index funds,

but they're not all market cap weighted index funds.

Market cap weights means that the weight of each company

in the index fund matches the weight of that company

in the market.

For example, RBC makes up 6.57%

of the S&P TSX Composite Index,

which represents the Canadian market.

So XIC, an ETF tracking the S&P TSX Composite Index

holds 6.67% of its assets in RBC shares.

In a market cap weighted index fund,

you end up with a lot of your money invested

in large cap stocks because they make up most of the market,

and a fairly even mix of value stocks,

which are stocks with lower prices

relative to their book value or earnings and growth stocks,

which are stocks with higher prices relative

to their book value or earnings.

Take a look at this style box analysis for XIC.

You can see that it is mostly large cap

and an even mix between value and growth.

There is nothing wrong with market cap weights,

but there is evidence that certain types of stocks

within the market should be expected to do better over time.

Two of the most prolific examples are small cap

and value stocks.

I know this may sound like active management,

but trust me on this one, you'll want to hear me out.

Let's start with the basics.

Index investing is based on financial markets

being efficient most of the time.

In other words, the market prices of stocks and bonds

are right or as close to right as anyone can get

pretty much all of the time.

In an efficient market, the price of a stock

contains a lot of information.

Expected stock returns are related to risk,

where higher risk generally indicates

higher expected returns.

Risk is reflected in prices and the way

that prices move over time.

There are models called asset pricing models

that help us to understand the relationship between risk

and expected returns.

Asset pricing models have evolved over time

as our understanding of asset pricing has gotten better.

There have been a lot of breakthroughs in asset pricing

and financial market research in the last 60 years.

And a lot of these breakthroughs have been related

to risk factors.

Let me explain.

If we take two portfolios, one 50% equity

and 50% cash and the other 100% equity,

we know that they're going to have

different expected returns due to the different levels

of exposure to the market risk factor, known as market beta.

Differences in exposure to market explains about two thirds

of the difference in returns between diversified portfolios.

If we took two portfolios, one with a 10% return

and one with a 16% return,

their relative exposure to market beta would explain

about 4% of the 6% return difference.

When we talk about breakthroughs and asset pricing,

we're talking about researchers discovering other risks

that consistently explain the differences in returns

between diversified portfolios.

The more independent risk factors that we discover,

the more of the difference in returns

between diversified portfolios we can explain.

There are hundreds of factors that have been documented

in the academic literature,

but only five or so of them are generally accepted

as being true independent risk factors.

The two that we were talking about today

are company size and relative price,

more commonly known as the value factor.

I hope you're still with me.

I have talked about factor investing in the past,

but not like this.

Today, we are going deep.

I mentioned market beta,

any discussion on factor investing

has to start with market beta, it was the original factor.

In the 1960s, the primary asset pricing model

was the Capital Asset Pricing Model or CAPM.

The CAPM looks at the measure of sensitivity

between an asset or portfolio and the risk

of the overall market.

That measure is what is referred to as market beta.

A market cap weighted equity index fund

would have a market beta of one.

A portfolio consisting of 50%

market cap weighted equity index fund

and 50% cash would have a market beta of 0.5.

If the market goes up 10%,

the portfolio with a beta of one would also go up 10%,

while the portfolio with a beta of 0.5 would go up 5%.

It's a measure for the sensitivity to market risk.

In its time, market beta was the only way

that we could compare two portfolios.

If two portfolios had different returns but the same beta,

the unexplained portion of the difference in returns

would be attributed to a manager's ability

to select securities or time to market.

A portfolio manager that can take the same amount

of risk while delivering a higher return

is of course desirable.

That excess risk adjusted return is known as alpha,

which is the holy grail of investing.

The CAPM was the foundation of asset pricing models,

but over time it was shown to be flawed.

As I mentioned earlier, market beta is only able to explain

about two thirds of the differences in returns

between diversified portfolios.

What about the remaining one third?

The CAPM was proven to be flawed

when Rolf Banz wrote his 1981 paper, The Relationship

Between Return and Market Value of Common Stocks.

He showed that small stocks

had consistently had higher average returns

that could not be explained by their market beta.

In other words, viewed through the CAPM lens,

small stocks were generating alpha,

excess risk adjusted returns.

In 1985, the CAPM took another blow

when Barr Rosenberg, Kenneth Reid and Ronald Lanstein

found that stocks with a high book value

relative to their market price,

commonly known as value stocks, had higher average returns

that were again not explained by market beta.

Their paper, Persuasive Evidence of Market Inefficiency

was further evidence that market beta

does not tell the full story

of how the market prices assets.

These findings at the time seemed to be proof

that markets were not efficient.

If some types of stocks

could have consistently higher returns

without any additional risk,

then the market is clearly mispricing those types of stocks.

If that is in fact the case,

then markets are by definition not efficient.

However, Eugene Fama, the man who originally proposed

the concept of market efficiency,

had a very strong rebuttal.

In 1992, Eugene Fama and Kenneth French

pulled together the anomalies

that had apparently been disproving market efficiency

and brought everything back to reality.

They showed that the market was still efficient,

but we needed to account for additional types of risk

independent of the risk of the market

in our asset pricing models.

Instead of the single risk factor model

that had been used for years,

Fama and French proposed a three-factor model

for asset pricing, including market risk,

the risk of small stocks and the risk of value stocks.

When they added in the independent risks of small

and value stocks alongside market beta,

they made the apparent alpha of small cap

and value stocks go away,

and they significantly increased the explanatory power

of the asset pricing model.

Remember that under the CAPM, small cap and value stocks

appeared to have higher average returns

without any extra risk.

The three-factor model showed

that they had higher average returns

because they were exposed to a different kind of risk

that is independent of the market.

Instead of explaining two thirds of the difference

in returns between diversified portfolios,

the three-factor model explains 90% of the difference.

At this point we have three independent risk factors

that explain the majority of differences in stock returns.

Since then, there have been a few more major breakthroughs,

but we are going to stop with the three-factor model today.

So why do we care about these risk factors?

Each of the risk factors, market beta,

size and relative price,

have historically delivered meaningful risk premiums.

Let's take a quick peek at some of that data.

First, we need to understand

how factor risk premiums are measured.

The market risk premium is measured as the return

of the market, like a market cap weighted index

minus the return of one month treasury bills

also known as the risk free asset.

The size risk factor is measured by the return

of small cap stocks minus the return of large cap stocks,

which is why it is referred to in the academic literature

as SMB, Small Minus Big.

The value risk factor is measured by stocks

with a high book value relative to market price

minus the stocks with a low book value

relative to market price,

which is why it is referred to in the literature

as HML, High Minus Low.

All right, so historically in the US,

from July 1926 through December 2018,

the market premium was 6.28% per year on average.

You get that by owning a market cap weighted index fund

like XIC for Canadian stocks, or XUU for US stocks.

SMB, the size premium, was 1.88% per year on average

and HML, the value premium, was 3.78% per year on average.

We're leaving those additional premiums on the table

with a market cap weighted index fund.

When Fama and French came up with their paper in 1992,

they were criticized for data mining,

because they only looked at US stocks.

That criticism was promptly addressed with global data,

which we now have at our fingertips.

We only have data going back to 1990 through 2018,

but globally, excluding the US, the market premium

has been 2.31%, the size premium has been 0.08%

and the value premium has been 4.29% per year on average.

In all cases the premiums are positive,

though clearly in some cases

they are more positive than others.

Global EX US SMB is not that exciting

with a premium of 0.08% per year on average.

I addressed this in detail in my video,

The Problem With Small Cap Stocks,

but in short, small cap growth stocks

with weak profitability makes small caps as a whole

look kind of bad.

If you take them out, which you can do

with the right index fund,

small caps look much, much better.

I want to talk a little bit about persistence.

I have heard some skepticism about the factor's ability

to continue delivering a risk premium into the future.

I would argue that anyone who believes

in the market risk premium has to believe

in the size and value premiums.

They are all based on markets being efficient

and accurately pricing risk into stocks.

If we do not believe in the size and value premiums,

then we should not believe in the market premium either.

If we look at rolling 10 year periods in the US

going back to July 1926 and through 2018,

the market risk premium has been positive 85% of the time.

The size premium has been positive 72% of the time

and the value premium has been positive 84% of the time.

Can we think about that for a minute.

US value stocks have historically been as likely

to beat growth stocks as the market has been

to beat one month treasury bills.

In Canada, value has historically beaten growth

over 10 year periods more often than the market

has beaten treasury bills.

In international stocks, we see the same story,

with the value premium being more reliable

than the market over 10 year periods

and international small stocks have beaten large stocks

with about the same frequency as international market

has beaten treasury bills, 88% of the time for the market

and 87% of the time for small cap stocks.

We are currently living through a period

where small cap and value stocks

have not been that great, even for the past decade.

From the data that we just saw, this is not abnormal.

In fact, it has happened many times throughout history.

But remember, we know from the data that this can happen

to the market, just the same as it can happen

to size and value.

This decade has been great for the market

and not so great for size and value.

Periods like this are expected to happen.

And historically, it has happened to the market

at least as often if not more often

than it has happened to size and value.

The past decade is not a reason

to abandon small cap and value stocks.

I think that these data are pretty compelling.

These factors aren't just some off the cuff observation,

they play a crucial role in our understanding

of financial markets and they have been as reliable,

if not more reliable than the market as a whole

at delivering positive risk premiums over time.

I don't know how anyone can ignore this data.

Now remember, if you own small cap and value stocks

in market cap weights, the weights that exist in the market,

you only have exposure to the risk of the market.

To get exposure to the independent risk

of small cap and value stocks,

you need to own them in weights

higher than they exist in the market.

Practically, this just means loading up

on some additional small cap and value ETFs

on top of your market cap weighted ETFs.

Unfortunately, there are no good ETS

to accomplish this for Canadian and international markets.

There are some good ETS for getting exposure

to US small cap value and value stocks.

Adding these ETFs

to a market cap weighted ETF model portfolio

increases its 20 year historical performance,

improves its worst three year performance

and decreases its standard deviation.

I have written about this in detail

in my recent paper, Factor Investing With ETFs

which is linked in the notes.

Now, I do want to add,

I am not saying that everyone needs to go

and buy small cap value ETFs to be a sensible investor,

just like not everyone needs to go and buy US listed ETFs

in their RRSP to increase their tax efficiency.

For many people, the simplicity of something like VGRO

is the best recipe for success.

I do firmly believe though,

that anyone who is already slicing up their portfolio

for lower costs or increased tax efficiency,

should be considering an allocation

to US small cap value and value stocks

to increase their portfolios diversification,

expected returns and statistical reliability.

In my factor tilted ETF model portfolio

that I propose in my recent paper,

I have used one third XUU or ITOT,

one third IJS and one third IUSV

for the US equity portion of the portfolio

to gain meaningful but cost effective exposure

to the US, size and value premiums.

To be clear, I do not invest

in this ETF model portfolio myself,

I use dimensional fund advisors factor tilted index funds

in my portfolio.

I try to avoid talking about dimensional on this channel

because you can't access their products

unless you're a client of my firm or a firm like it

that dimensional has approved.

My ETF model portfolios are my attempt

at making factor investing accessible to any DIY investor.

Have you thought about adding small cap and value ETFs

to your portfolio?

Tell me about it in the comments.

Thanks for watching.

My name is Ben Felix of PWL Capital,

and this is Common Sense Investing.

If you enjoyed this video,

please share it with someone you think would benefit

from the information.

Don't forget, if you've run out

of Common Sense Investing videos to watch,

you can tune in to weekly episodes

of the Rational Reminder podcast

wherever you get your podcasts.

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