Recently, a member asked me whether the Quantitative Value strategy (or any strategy for that matter) can be improved by limiting it only to small caps, or even micro-caps.

It was a well-warranted question. The premise that small stocks could deliver higher returns than large-cap stock is well-known for decades. In 1993, Nobel Laureates Fame and French published their paper Common risk factors in the returns on stocks and bonds, which added to this well-known fact an academic Kosher stamp.

So would a portfolio restricted to investing in only small caps perform better than an all-cap portfolio?

Let’s run some tests for a Quantitative Value portfolio of 30 stocks. As usual, our backtesting simulations span 19 years – June 30th, 1999 to June 30th, 2018.

The first figure is for an all-cap portfolio created from a universe of stocks with a market cap in the 30% percentile (about ~$30M in today’s prices) or higher.

Let us now modify our universe of stocks to include only microcaps. In the following simulation, we allow stocks in the 10% percentile of market cap (about $10M in today’s values) and up to the 50% percentile (about $500M in today’s values).  Here are the results.

A side by side comparison is brought below. On the left side – the microcap portfolio. On the right side – the all-cap portfolio.

For the entire simulation period of 19 years, the microcap portfolio has resulted in marginally higher returns. Its average annual returns, 18.98%, is slightly higher than the all-cap portfolio’s returns, of 18.93% per year. Over the 19-year period, the microcap portfolios edge over the all-cap portfolio was a mere 20%. Not a big of a deal.

Nevertheless, as expected, the micro-cap portfolio was more volatile. Its standard deviation figure, a measure of volatility, came in 14.07%, vs. the all-cap portfolio of 13.18%. The increase in volatility, coupled with the almost similar returns, resulted in a lower Sharpe ratio for the microcap portfolio, at 1.19, vs. 1.126 for the all-cap portfolio. Another expected result was the lower correlation of the microcap portfolio with the benchmark (S&P 500), at 0.50, vs. the all-cap portfolio of 0.68.

How can that be? Why doesn’t a micro-cap portfolio perform significantly better than an all-cap portfolio which contains not only small caps but also large caps? Shouldn’t small caps win?

To come up with a plausible explanation, let’s consider how the Quantitative Value portfolio works. QV filters the universe of stocks for cheapness and keeps the 25% cheapest stocks. Then, it ranks and sorts the stocks according to a composite quality rank and selects the highest quality stocks out of the cheap bucket. The fewer limitations we put on the universe of stocks, the higher changes that our quant screeners select the best stocks – the cheapest and the highest quality ones out of the cheapest. The all-cap portfolio, for that matter, is less restrictive. Small caps may beat large caps, but all-caps beat then any-cap.

Think about it this way. Not every microcap is cheaper than a mid-cap or a large-cap. On average, microcaps tend to be cheaper. But in practice, there are quite a few cheap stocks among mid-caps and large-caps, and we wouldn’t want to miss out of them. Quality behaves the opposite. On average, large-caps tend to have higher financial quality than micro-caps. Usually, their underlying businesses are more diversified, have better access to capital, and are run by more capable board and management teams. In practice, of course, some microcaps may enjoy better financial quality than some large-caps. But which of the effects takes precedence? Will large caps perform better than small caps, just because they possess better quality? Will small caps perform better since they possess a lower valuation?

With an all-cap portfolio, we do not need to guess. Cheap stocks with the highest quality are automatically selected for us. And indeed our experimentation shows that the best risk-adjusted returns are achieved with the all-cap portfolio.

While our 19-years simulation results should be our guiding post, let’s examine the return profile for the last three years, listed in the table above. During that period, the microcap portfolio returned 79%, 10% better than the 69% for the all-cap portfolio. Its volatility was higher, at 21.4%, vs. 19.28% for the all-cap portfolio. In total, the microcap’s portfolio’s Sharpe came in 1.49, lower than the all-cap portfolio Sharpe of 1.58.

For completeness, we would like to bring the results for the yearly returns of both portfolios.

Let’s start with the all-cap portfolio:

And for the microcap portfolio:

The returns profile are not materially different. In most of the years,  both portfolios beat the benchmark. In some of the years, they fail to beat the benchmark. Note that the microcap portfolio had a two-year losing streak (compared to the benchmark) during 2013 and 2014, but still managed to deliver good returns.

There is no single diet which fits all. Similarly, there is no single investment plan which fits all. Some (like I) may be comfortable with investing in an all-cap portfolio. I believe it is evident from the article above. Conservative investors, and also institutional investors, may want (or need) to limit their holdings to the safer mid-caps and large-caps. Enterprising investors may want to take a shot and skew their holdings towards microcaps. All these methods are legit. The good news is that the Quantitative Value Screener on this website (available to Premium members) allows everyone to customize it per their market cap preferences.

Happy Investing.