Microcap Value Stocks

One comment on this...there's a lot more "dispersion" with microcap value stocks, meaning differences in returns among stocks meeting the criteria defining the asset class. I don't recall the exact quantification of this, but it's an issue with value stocks generally. Your 28 might not be nearly enough to achieve the returns of the asset class, because you're likely to miss the very big gainers that fuel returns.

As an example DFA's microcap fund holds over 2,000 stocks, and the small-value fund over 1,000. Compare this to say Large-cap US stocks...the Dow 30 has very similar long-term returns to the S&P 500, and their day to day changes are about 92% correlated. If you picked 28 random, large-cap stocks, your returns would likely be highly correlated to the Dow or S&P 500. That's not necessarily true with the smaller issues.

-Tad

If you select microcap value stocks randomly, I agree with you 100 percent: you need a lot of more stock holdings than just 28. In fact, only 44 percent of value stocks have positive returns in the 2-yr period after portfolio formation. However, if you select your stocks based on a record of strong performance -10-yr performance- then you don't need thousands of stocks to obtain a good return for your investment (see, for instance,

In fact, my methodology was to depart from the 331 microcaps included in the Zacks index (Powershares' ETF PZI tracks this index), and select only those stocks with the strongest performance record (as measured by a record of increasing earnings, free cash flow and low debt/equity ratio) AND at least 25 percent undervalued (as measured by the intrinsic value calculated by CapitalIQ, a division of Standard and Poors). Since I selected ONLY those value stocks with the best performance and more undervalued, I think that my strategy does not need 1000 stocks to yield good results.

You may wish to check the characteristics of my portfolio, included in this newgroup to discuss small and micro cap value stocks:

the average stock in my microcap value portfolio has a marketcapitalization of $237 million, a P/B of 1.29, a P/E of 11.4, a ROE of15.6 percent, and it is undervalued (based on the market consensus onfuture profits) by about 46 percent. I don't think that DFA would beatthat.

Tad Borek wrote:

By the way, DFA microcap portfolio is hardly a microcap value portfolio, but a broad cross-section of microcap stocks. This is important, since the overperformance comes from small and micro VALUE stocks, not from small/micro growth stocks, which actually have the lowest average rate of return of all categories of stocks (divided by size and style). In fact, the 10-yr average rate of return of DFA microcap is 12.8 percent, substantially lower than the 21.13 percent yield of the representative microcap value portfolio during the last 10 years (see

, basedon Fama and French data).

snipped-for-privacy@gmail.com wrote:

======================================= MODERATOR'S COMMENT: Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.

Jose, it sounds like you're creating what is in effect an active-management method based on the Fama-French findings. If microcap value is the part of the market with the highest expected returns, why not cherry-pick within microcap value based on some methodology?

Which is fine, and makes sense -- but of course it depends entirely on whether the methodology you use is likely to filter out stocks that are going to outperform the basket of the hundreds that meet the criteria of "microcap value." And it departs from the F-F conclusion which would be to buy the basket of stocks, because of its risk characteristics, while assuming that the market efficiently prices the individual issues within the asset class.

"Strong 10-year performance" might actually be a poor criteria. It could identify the stocks you should have bought 10 years ago, rather than the ones you should buy today. I might look for the worst 10-year performers, alongside some other criteria...my belief is that the outperformance of value stocks, as an asset class, relies in good part on the "return to grace" of companies that are currently doing poorly. Of course within that is some garbage (risk) which is why it makes sense to diversify broadly.

-Tad

I agree. When I talk about strong past 10-yr performance of the companies I select, I'm talking first about their ability to earn a profit (increasing profits), then I look at their cash flows (to check that the profits are effectively there and not just on paper) and finally the debt/equity ratio (only stocks with decreasing D/E are selected). These are the most important fundamentals that come from the income statement, cash flows and balance sheets of these companies.

Then it comes the critical factor: valuation. Given their past performance, I make a (very) conservative assumption on future earnings growth. If market values for every company are well-below future discounted earnings, I buy the stock. As a reference, my small and micro cap value portfolio had a weighted average earnings growth of

19.62% during the last 10-yr period (well above the market average), and I'm assuming expected growth of 5.1 percent per year in the future. This is about 80 percent of the historical earnings growth recorded by the market as a whole, which has been 6.1 percent since 1950. My assumption is even more conservative if we believe that micro and small cap stocks with strong performance in the past usually outperform the earnings growth rate of the market as a whole.

Tad Borek wrote: