“Small-Cap Value” Is Not Just Value With A Smaller Size Filter

Small-cap and large-cap stocks don’t just differ in terms of size. These classifications involve two very different kinds of companies that require very different approaches to analysis. It’s not a statistical thing: The difference involves fundamentals. So when searching for small-cap value, it’s important to avoid using the same approach one used for large-cap that only changes the size requirements. Here’s an approach to small-cap value “investing” that can work even today, even though the value “factor” is cold.

For Starters: “Value Investing” Versus The “Value Factor”

Value investing works. It always worked in the past. It works now. It will always work in the future. To suggest otherwise would be to deny human nature, the tendency to buy something at a lower price and to bypass an offer from one who sells the exact same product or service at a higher price. A rational buyer will pay a higher price for something only if there is a particular reason to do so (better service, more convenient method of shopping, better buying experience, better warranty, not knowing of a cheaper alternative, etc.).

In an ideal market, a higher price (P/E) will be associated with a better company. Financial theory tells us to evaluate P/E in terms of the expression 1/(R-G) where G is expected Growth and R is required rate of return, which depends on market interest rates, a premium for investing in risky equities as opposed to risk-free fixed income, and another premium to reflect company-specific risk/quality. For details on the logic behind this, see my large-cap value screen post or the strategy design cheat sheet posted on my blog site. 

The fun occurs because we all have our own ways of assessing 1/(R-G) and come up with different (sometimes wildly different) answers. But however we go about it, this process, matching up the level of the price we pay with the merits of the company we get, is what “value investing” is all about. This process always works, but we don’t all implement it with equal effectiveness. Those who are great at it become known as legendary value investors. Those who screw it up a lot tend to complain that value investing is for losers.

The value factor, on the other hand, (the thing about which Fama, French and countless followers talk about) is an altogether different animal. It’s simply a best-to-worst sort of a preferred value ratio. Academicians tend to like BM, book to market, apparently forgetting what else BM stands for (until they need to go for a colonoscopy) leaving the rest of us to describe it as PB, Price to Book; many others prefer P/E, P/S, P/FCF, stuff with EV, etc. The value factor is said to work when low valuation (or high BM) stocks outperform low valuation and is said to be cold when high valuation outperforms low valuation.

Goldilocks

Since the value factor does not consider1/(R-G), there will, as many have seen, be times when the value factor works and times when the value factor fails. The fortunes of the value factor depend on the variability of trend (mean reversion). Investors often (very, very often — downright habitually) over-interpret the past and assume that what we saw will continue to be seen forever. When reality steps in and turns things around, those who are caught with high ratio stocks get slammed (because the trees they supposedly held did not grow to the sky after all) and those who owned low-ratio laggards get rewarded when those former duds improve. In that environment, the value factor works.