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Small Stocks Large Effect

By: Richard Feldman

By: Richard J. Feldman, CFP, AIF, MBA

The old saying no guts no glory is well represented in the world of microcap stock investing. Microcap equities are the wild west of equity investing. Small companies offer the chance for large investment returns (think of the next Microsoft) but the risk of a company going under is greatly magnified when investing in this sector of the market. Engineering a portfolio to take advantage of the size effect (small cap stocks have higher expected returns than large cap stocks) can lead to incrementally higher portfolio returns with out any increase in volatility as measured by standard deviation. Microcap stocks are the smallest segment of the small cap universe. The Center For Research In Security Prices (CRSP) database breaks down the New York Stock Exchange into ten deciles. The first being the largest and the tenth being the smallest. Typically microcap mutual funds investment universe is the ninth and tenth deciles or the smallest 20% of all stocks on the NYSE, NASDAQ, and Amex stock exchanges.

Russell Microcap Index

Russell and MSCI have both recently developed new indexes to replicate the performance of the microcap universe. Russell’s research shows the universe of microcap managers performs differently than that of small cap managers. Most microcap managers feel the Russell 2000 is not an adequate benchmark for microcap funds due to the notable differences between average market capitalization and median market capitalizations of equities held in the funds. The weighted average equity market capitalization of the Russell 2000 Index at year end was $865 million compared to an estimated $276 million for the new Russell Microcap Index. Companies with market capitalizations of under $500 million behave differently than companies in the $500 million to $2.5 billion range. Reasons may be limited product lines or limited access to capital for smaller companies.

S&P 500 Vs DFA Microcap (Microcap Proxy)

 

Comparing the results of a proxy for the CRSP lower deciles (DFA Microcap Fund) and the S&P 500 you will notice that the DFA microcap fund has a much wider dispersion of returns than the S&P 500 meaning that the volatility of the fund is higher than the S&P 500. To follow is a bar chart of the returns of the DFA Microcap fund and the S&P 500 Index on yearly basis from 1982 through 2004.

 

This twenty two year time period shows you that the returns of the two asset classes varies significantly year to year. Microcap stocks can severly outperform or underperform in any given year but do tend to correlate to a certain degree with the S&P 500. The correlation coefficient between the DFA Microcap Fund and the S&P 500 is .595%.

Portfolio Diversification with Microcap Stocks

Adding microcap stocks to a large cap equity portfolio can lead to increased portfolio returns and lower standard deviation of the total portfolio. Modern Portfolio theory shows us that you can add a riskier asset class to an equity portfolio and increase the expected return while lowering the volatility. If you look at adding the DFA microcap fund to a portfolio made up entirely of the S&P 500 from 1982 – 2004 you would have achieved a higher rate of return and lower volatility.

Port1 Port 2 Port3
DFA US Micro Cap Portfolio (USD) 100% 0 30%
S&P 500 Index (USD) 0 100% 70
Total 100% 100% 100%
ANNUAL DATA:
Average Return 16.08 14.81 15.19
Standard Deviation 20.23 16.1 15.66
Total Return 2087 1796 1983
ANNUALIZED DATA:
Portfolio Return 14.35 13.65 14.11
Standard Deviation 20.23 16.1 15.66

Source: DFA Returns Program

The DFA microcap fund over the past 22 years has outperformed the S&P 500 Index on an annualized basis 14.35% to 13.65% respectively. Looking at a portfolio of 70% S&P 500 and 30% DFA Microcap rebalanced annually you would have achieved a higher rate of return and a lower Standard Deviation (See Port3 Above).

Summary

Microcap stocks on an individual basis are very risky and should not be purchased by the average retail investor. Adding an index of microcap stocks or a mutual fund of microcap stocks to a diversified portfolio can lead to an incremental increase in expected return with lower volatility. If you are looking for pure exposure to small company stocks for your portfolio than a Microcap fund or a fund that focuses on the CRSP 9th and 10th deciles is where you want to be.

To follow are the top holdings of the DFA US Microcap fund through March 31st of 2005. Would you recognize any names on this list?

% of Portfolio / Cumulative%

 

CHATTEM, INC. 0.24 0.24
RAVEN INDUSTRIES, INC. 0.22 0.46
STERLING BANCORP 0.22 0.68
FRONTIER OIL CORP 0.22 0.90
MOVIE GALLERY 0.22 1.12
CYBERONICS INC 0.21 1.33
ALERIS INTERNATIONAL INC 0.19 1.52
M/I HOMES, INC. 0.19 1.71
SANDERSON FARMS, INC. 0.18 1.89
REMINGTON OIL & GAS CORP