Some of the more compelling factors that have been cited as arguments against the existence of a size premium include: measurement error, inferior profitability comparisons, and the erratic nature of spikes in small-cap returns. Another popular but qualitative argument holds that small companies are inferior to large companies in terms of product and services, management depth, balance sheet, and similar factors. Other relevant issues investors must reconcile, before taking on a small-cap position, relate to the illiquidity of small stocks, which interferes with the ability to invest quickly.

Flaws in Performance Data

Historical data are always subject to frailties of human error. By extension, a measured effect is only as good as the database from which it is drawn. One way in which critics debunk the size premium is to claim that the data are flawed. They argue that databases tracking security prices as far back as the 1920s must contain some degree of error. Yet the services that provide such pricing data claim that they accurately capture all events that have been transacted in the equity markets. Factors such as survival bias, or databases that do not account for companies that have gone bankrupt or not “survived,” or other data hitches such as flawed data entry, certainly leave open the possibility that compelling small-cap returns have been measured less than perfectly.

Because of the robust sample size, however, it becomes difficult to argue that errors in the data, which are clearly drawn at random, consistently bias the smaller stock returns. The sizable universe of companies makes it more likely that the measured returns over the long term are closer to the realized returns.

Another issue that has surfaced relates to the definition of small stocks. According to this argument, as laid out by Bill Fouse, small stocks have generated excess returns in the past because large companies were accidentally included in the sample of small companies. In the initial studies on size, size groups were reconstituted over five-year periods, which meant the sample size of the small-cap index remained unchanged for five years. As a result, some of the more successful small-cap ideas could have migrated to the large-cap universe but were mistakenly credited to the small-cap universe. Although this argument has some merit, the lengthy five-year holding period would also be likely to cover collapsing secondary stocks that small-cap investors would be unlikely to hold. These stocks, which would be incorrectly credited to the small-cap index, would detract from small-cap performance measures. Accordingly, it might be more appropriate to assign weakening issues to a group outside the small-cap universe. For instance, faltering secondary stocks that are losing market value might be more appropriately assigned to a segment of microcap stocks. Even though the upward migration of shares can produce an upward bias in small-cap benchmarks, downward migrations can likewise create a downward bias in returns. Although investors need to examine all benchmark results with a critical eye, a migration bias may be less relevant than other issues. Because the markets are fluid, there are always likely to be migration effects, whether upward or downward. Over the long term, these effects are likely to cancel each other out and have little impact on any potential return bias.

To determine the significance of the migration effect, the holding periods of a small-cap benchmark could be shortened-for example, from five years to four years. The benchmark results could then be analyzed to determine whether they are significantly different when the rebalancing frequency is cut down to three years, two years, or one year. In one simulation, several identical small-cap portfolios were created to vary only by the length of the holding periods. The portfolio results were nearly identical. Based on this study, there seems to be little evidence that the performance of a small-stock index calculated over a five-year holding period varies greatly from that of an index with a four-year holding period. In fact, the results appear to be fairly uniform across holding periods.

The significant number of companies that comprise the small-cap market accounts for the stark similarities among small-cap benchmarks reconstituted across holding periods. In other words, once a benchmark is constructed with several hundred companies, as most small-cap benchmarks are, the averages are more likely to converge, reflecting quite similar results. Although index turnover can appear significant, the net performance results do not necessarily vary because of the tendency for a broad core of small-cap names to remain in an index over lengthy periods.

Suspect Small-Cap Cycles

The size premium has also been questioned in relation to performance cycles. In an argument posed by Jeremy Siegel, a Wharton School professor and noted author, the degree to which small stocks outperformed large stocks in the 1970s was unusually strong and possibly suspect. According to this thinking, if the 1974-83 period were removed from the long-run performance analysis, the remaining data would yield a large-cap premium.

That ten-year-period appears to have represented a bonanza for small-stock investing. Figure 6.2 presents the performance of the Ibbotson Small Stocks Index versus that of the Standard & Poor’s 500. Note that the long-run data from 1926 to 1999 indicate that a dollar invested in small-cap stocks would be worth approximately $6,545, compared to approximately $2,842 for large stocks over the same time frame. If the years 1975 through 1984 were removed, however, large caps would have generated $2,004 and outpaced small stocks, which would have gained only $1,202 over this period.3 The period in question represents an unusual time, one of oil shocks and devastating inflation. Although it might seem reasonable to remove an anomalous subset of returns, this analysis neglects the possibility that unusual events have occurred in practically every decade. If the 1975-84 period were removed from the analysis, this elimination would also erase a bear market for large caps that occurred during the first half of this time frame. This approach inadvertently assumes that investors can adeptly time a large-cap bear market. It turns out that besides being a period in which small-cap returns were stellar, the 1970s also marked a bear market for large-cap returns.

Figure 6.2: Small-cap cycles in good and bad times

Likewise, most of the subsequent period from 1984 to 1991 should be removed from analysis because large stocks exhibited unusually high returns during those years. In this time of severe disinflation long-term government bond yields fell from the mid-teens to roughly 5 percent over a 10-year period. Investors are unlikely to face such a significant period of disinflation within the foreseeable future. If the 1984-91 period were removed from the analysis, the long-run performance results, not surprisingly, would show that small stocks outperformed large. In fact, as presented in Figure 6.2, the margin of small-cap outperformance would be even greater than that of the long-run time series data. As this discussion demonstrates, selective measurements can cloud any analysis, including an analysis of the small-cap premium.

Excerpted from Small-Cap Dynamics (c)2000 by Satya Dev Pradhuman. Reprinted by arrangement with Bloomberg Press.
September 07, 2006

Small Caps Outperform Large: Fact or Fiction? was originally featured in the Penny Sleuth.

*** Hopefully, by now, you have received your invitation to join Carl Waynberg and his GRIP system — on what promises to be an exciting small-cap journey through the OTCBB and Pink Sheets markets.

If you’ve ever wanted to dabble in true penny stocks — this is your chance.

We’re only letting 3,000 people join. So if you haven’t signed up yet, please do so quickly. You have until Jan. 1 to sign up and receive your 80% discount. But once the new year rolls around, the entry price will more than double! So please take advantage of this limited time offer.

*** “James, have you looked at shares of VSL in a while?” asked Penny Stock Fortunes editor Angela Roberts over instant messenger yesterday afternoon.
“They’re up over 30% since you got in!”

Of course, I had been watching. And the rise really didn’t surprise me — although it was welcomed. You see…

VSL is the ticker symbol for Indian telecom giant Videsh Sanchar Nigam Ltd. Its headquarters are just outside of Mumbai, India (also known as Bombay here in the West). And it is widely considered the AT&T of India — connecting India with 237 international destinations around the world.

I recommended shares of VSL last winter — when they were going for $7.95 a share. At the time, that was dirt cheap. You see, the company was trading for seven times earnings and less than book value. Plus…

India was adding 2 million phones a month, and GDP was predicted to keep growing right around 8% a year. Recommending VSL seemed a no-brainer. And today, less than one year later, shares of VSL are trading for $10.39. We’re up 30% in 10 months. Not a bad return on your investment.

So why the huge rise?

One could argue fundamentals. The stock was inherently undervalued at the time. But in this case, I think it’s something more than simple stock fundamentals.

I recommended shares of VSL because it was an Indian stock. I knew India had a serious chance to become the “Next Asian Superpower.” It had the people power. It had the technological know-how. (Bangalore, located in southern India, is widely regarded as the Silicon Valley of Asia. In fact, more IT directors work there than in Silicon Valley!) And if India emerged like China did, companies like VSL and Mahanagar Telephone Nigam Ltd. (MTE) — the other Indian telecom company I recommended — would rise.

Well, that’s happening. India is growing. Its stock market is up 14% in the last year. And liquidity is improving each month — especially the market for small-cap stocks (which is where the HUGE gains are being made).

Nikhil Lohade, writing for India’s Business Standard reported that…

“The current market rally (in India) has seen steep gains in heavyweights, but the true sizzlers have been the penny counters, according to retail brokers.

Data show that small-value scripts have far outshone their more recognized peers in terms of meteoric gains in their prices.”

Lohade goes on to quote Rajesh Kamdar, an Indian dealer at KG Vora Securities…

“The current rally has been driven by liquidity, mostly foreign, in front-line stocks. But retail participation has been huge in smaller stocks.”

Translation…

Indian small-cap stocks are rising because a lot of foreign money managers are dumping cash into the market now. They are seeing the opportunity that exists in India (especially with the smaller companies on the major Indian exchanges). And they are buying, buying, buying.

That’s exactly why shares of Indian stocks like Capman Financials, SGN Telecoms, Howard Hotels, Yashraj Containeurs and Polymechplast Machines are up anywhere between 347-1,405% a pop. And it’s exactly why shares of VSL are up over 30%.

As a small-cap investor, it’s important to recognize opportunities all over the world. And as we move into a new year, there will be hundreds of chances for you to make money. Not all of them will be in U.S. stocks. In fact, the best opportunities to really multiply your money are ALWAYS in an emerging market — like India or China.

In fact…

*** Dan Denning, editor of Strategic Investment, just send me the latest ETF inflows report. It shows where the “smart money” is flowing. For the week ending Dec. 24, $1.2 billion was dumped into ETF funds. And the two standout winners were foreign funds and small-cap funds. Check it out…

Foreign and global funds received $304 million, while $423 million poured into the Russell 2000 small-cap fund — IWM. Collectively, 60% of the total equity inflow went to buy small caps and foreign stocks…and a pretty bullish sign for the argument I am trying to make.

As you think about your own investment strategy for 2005, you would do well to
consider small-cap stocks and emerging markets. So…

Who knows what the next emerging market will be?

I expect India to be a force for the next decade — which is why we are still holding onto shares of VSL. But I also expect countries like Mexico, Nicaragua, Argentina and other Latin American countries to emerge.

Look for more on emerging markets here in Sleuth. I have a feeling we’ll find more than one opportunity to help you profit in 2005. But for now…

Irwin is going to take you on a retrospective look back at the U.S. small-cap market of 2004. It was quite a bumpy ride — that’s for sure. But those who stuck with us…well…they made some nice money.

Irwin, what the heck happened this year?

Gunning for Profits in 2004

What’s the single most important lesson we small-cap enthusiasts learned in 2004? My friends, it’s this: Stick to your guns.

Congratulations to those of you who held fast during the razor-thin election polls, earth-shattering crude prices and Greenspan’s serial interest rate hikes. Because the Russell 2000 small-cap index rewarded us yesterday with an all-time high of 651.72. Incredible!

The Russell 2000 fought hard for each and every winning point — reminding me of boxing legend Muhammad Ali. The Russell 2000 danced on its toes in the early quarter, and then sustained body blows in the middle quarters, only to finish with a dazzling victory. And here in Baltimore, your devoted Penny Sleuth team was ringside throughout.

We went into the year fully aware that small-cap cycles typically last 5-7 years. Since our current cycle started in 1998, we knew that things could turn on a dime. Remember: Small-cap stocks are the first to react to market changes — either up or down. Yes, your Penny Sleuth team was enjoying the ride, but frankly, some folks here were starting to pensively nibble their lower lip.

We spent many late nights during 2004 holed up in the office analyzing the charts, graphs and newswires until our eyes were bloodshot. I’ll admit that, like yourself, we were tempted to cut expectations, flip-flop investment strategies or sell off everything as we prayed for saner times. But we didn’t. And I’ll tell you why…

Here at Penny Sleuth headquarters, we have volumes and volumes of data at our disposal. We constantly study what happened in previous bull markets. And we had a strong hunch that this bull run would continue all throughout 2004. After all…

From 1926-1996, small-cap stocks consistently outperformed large-cap stocks. After 10 years, small caps beat large caps 67.7% of the time, that number growing incrementally over longer periods to a full 100% after 25 years. That’s a scientific fact. And the major reasons for it are innovation, undervaluation and volatility.

Taking those three criteria into consideration, our bull market outlook had a slight permutation to it. While the first quarter was characterized by high-risk speculation, we expected that to change into a longer-term, more conservative holding pattern as the election approached. Regardless, whether it was raw profit-taking or long-term investing, we had no reason to believe that small caps would disappoint.

In part, that’s because we knew that when it comes to innovation, small-cap
entrepreneurs are a driving creative force behind the kinds of inventions that large-cap companies ignore…opening the door for a windfall. Look no further than Cyberonics, Inc., Acacia Research Corp. and SiRF Technology Holdings, Inc.

Cyberonics is a maker of implantable medical devices that treat neurological disorders. When it announced FDA approval of its patented epilepsy treatment, on June 16, the stock shot up the next day by $15.23, or a whopping 78%. Imagine that a 78% gain in 24 hours. That’s the kind if innovation that you find with small-cap companies. And a 78% gain is the kind of a return you can get if you stay committed to your investment strategy.

On March 15, Acacia announced a deal with Playboy for its state-of-the-art patented streaming media system — sending Acacia’s stock up 14.5% over the next four days, from $6.13 to $7.02.

And Aug. 31 saw an announcement from SiRF that Microsoft was adopting its global positioning system for a travel and mapping application. Bear in mind that SiRF has 71 U.S. patents and 96 U.S. patents pending. That innovation coupled with Microsoft’s market clout catapulted SiRF’s stock into the stratosphere for the entire month of September, going from $9.98 on August 31 to $14.04 on Sept. 28 — a breathtaking climb of 40.7%.

One more important point about small-cap profitability before we continue.

Since the stocks are generally undervalued, they have a much greater capacity for rapid growth (and decline) than the more mature and stodgy large-cap stocks. After all, when was the last time you saw IBM, Procter & Gamble or General Motors shoot up 78% overnight? It’s nearly impossible.

And that kind of small-cap growth occurs year in and year out.

In 2003, the Russell 2000 gained a record 47.3% — crushing the large-cap
Russell 1000, which itself posted an impressive annual rise of 29.9%. That 17.4% gap marked the fifth straight year that the Russell small-cap index left its bigger brethren in the dust. Racing across the finish line of 2003, we entered 2004 with the pedal to the metal.

Strapped in for a great ride, the first three months of 2004 were amazing. The Russell 2000 surged ahead 73% over Q1 2003. Small-cap adrenaline junkies ignored the grim reports of unemployment, Mid-East insurgents and Haliburton. Euphoric on the fumes of 2003, they extracted heady profits from the small-cap boom.

For example…

If you owned stock in biotech star Incyte Corp., your Q1 price increase rose 21.9%, from $6.82 to $8.31. Tech company Input/Output, Inc. also made small-cap investors big money in the first quarter by jumping from $4.65 to $7.75 — an increase of 66.7%. And Whiting Petroleum Corp. scored a 25.2% gain as it went from $18.84 to $23.59 for the quarter.

You could just hear Prince singing, “I’m gonna party like it’s 1999.” But in retrospect, that was the anthem for the tech bubble burst of 2000. So we should have known that the encore would be a cry of panic.

Going into Q2, sharp job gains and other positive indicators set off chatter about short-term interest rate hikes. For us, that was bad news. Even thriving small companies often need cash to stay competitive. They spend the money on important programs such as R&D, marketing and channel development. But any company with a market cap of $1 billion or less is considered high risk by steely bank officers. That translates into higher interest rates, which come straight off the bottom line.

Toward the end of Q2, gargantuan monsters that went by the names of Ivan, Jeanne and Frances messed up oil producers in the Gulf of Mexico. In conjunction with other oil industry worries, the worst hurricane season in 40 years triggered wild speculation in oil prices — with the logical effect of weakening stocks. Naturally, investors ducked for cover. Dumping their riskier small-cap holdings, they made a bee dive for large caps.

By the way, there was one more hurricane — of the financial variety — that went by the name of Alan. In June, when meteorologists started predicting a nasty hurricane season, Chairman Greenspan bumped up short-term interest rates for the first time in four years, by a quarter point.

So for the second quarter, the large-cap Russell 1000 surpassed the Russell 2000 — for the first time in five quarters. The Russell 2000 returned a paltry 0.47%, compared to the Russell 1000′s yield of 1.40%. Although the spread was 197.9% in favor of the large caps, neither of the indexes set off fireworks. But the reversal would start a downward small-cap trend.

We began to wonder…

Had the small-cap rally of 1998 finally hit a wall? Were the artificially low short-term rates merely a facade for small-cap companies with lousy fundamentals? And would fund managers completely rotate out of small caps in favor of Wal-Mart, PepsiCo and ConAgra — smashing our favorite stocks?

These questions and others plagued us here at Penny Sleuth late into the night. Crunching numbers, downing coffee and dissecting research, we couldn’t help but wonder if the sirens screaming by our office every five minutes were an alarming metaphor for the Russell 2000…and a small-cap rally reaching its theoretical limit.

As expected, large caps outperformed small caps for Q3 — although both coughed up a negative return (unexpected). The Russell 2000 lost 2.9% versus minus 1.8% for the Russell 1000. But we weren’t ready to throw in the towel yet. We knew small-cap stocks were in a massive bull run. And we were right.

Here’s a snapshot of the forces at work going into the fourth quarter…

To fight inflation, Greenspan’s interest rate hikes had reached 2%. But postelection rapture overcame the extra financial burden to small-cap entrepreneurs by sending the Russell 2000 upward from 585.44 on Nov. 3 toward what we believed at the time was an all-time high of 609.61 on Nov. 10.

But think again…

Because yesterday, the Russell 2000 became the only major stock index to eclipse its highs from the mighty bull run of 2000 by setting yet another record of 651.72.

The groundwork for this phenomenal performance was laid during the month of
November, when the Russell 2000 rose 8.8%. If you annualized that out, you’d be looking at a 70% gain for the year. Not bad. But if you annualized the Russell 2000′s performance from November, you’d be staring at gains of more than 170%.

And it got better for us small-cap fans…

During the first 11 months of 2004, the Russell 2000 was up 15%, doubling the gains of the large-cap Russell 1000, which was up only 7.5% for that period.

Here at Penny Sleuth, we were definitely sleeping easier. Still, the theoretical limit of the 1998 small-cap rally hung over us like the Sword of Damocles. Until we discovered a little-known study published by a company that sent Wall Street topsy-turvy.

Ibbotson Associates had published that shocking study that I cited earlier, which showed how small-cap stocks had beat large-cap stocks from 1926-1996. Its publication in 1999 rattled the blue bloods of Wall Street, who were born and raised to believe that large-caps ruled. Then we came across another startling piece of research from Ibbotson.

In it, they insisted that 1999 was just the beginning of a 26-year small-cap run that would once again beat the returns of the large-cap elitists. Ibbotson and company believe that through the period 1999-2025, small caps will yield a total return of 12.5%, versus 11.6% for large caps.

In the end, we were always believers. And we knew that you were too. That’s why on Oct. 12, we launched Penny Sleuth — the best guide to the small-cap universe ever to hit the Internet.

How long will the current rally last? Nobody can say for sure. But we’re sticking to our guns at least through 2025.

Happy investing,
Irwin Greenstein

December 25, 2004

P.S.
Since the past and the future are inextricably linked together, on Friday James will share his small-cap forecast for 2005.  He’s keeping it tightly under wraps until the last possible minute (even I haven’t seen it yet).  So I’m just as anxious as you are to read Friday’s Penny Sleuth.

Gunning for Profits in 2004 was originally featured in the Penny Sleuth.