Small company, higher quality “value” stocks

Small company, higher quality “value” stocks are better long-term investments than large company growth stocks.

Small cap value stocks are assets that may be temporarily undervalued by investors. These companies typically grow at a slower pace than the typical company.

Over the past decade, growth stocks have largely outperformed small cap value stocks.

Small cap value stocks are currently undervalued by the market. If investor sentiment is correct and other investors ultimately recognize the value of the company, the price of these stocks may rise over the long term.

Historically, the stocks of smaller companies have outperformed those of larger companies. And relatively inexpensive stocks have outperformed more expensive stocks.

Over a long term, small cap stocks deliver superb investment returns, better than any other asset class and many percentage points better than the equity market as a whole. And, there exist a body of research that shows that over a long investment horizon, small cap stocks have outperformed their large cap brethren. From 1928 through 2014, U.S. small-cap value stocks turned in a compound annual return of 13.6% compared with 9.8% for the Standard & Poor’s 500 Index.

Finance professor Kenneth French and Nobel laureate Eugene Fama, say that “…small company value stocks are better long-term investments than large company growth stocks, though they add (naturally) that they are also riskier.”

Currently, small company, higher quality “value” stocks are trading at their biggest discount since the dot-com bubble in 1999-2000.  But it is important for investors to invest in small cap stocks that have the “quality” factor and their corresponding discount are the reason that quality has become the significant factor in explaining the sectors out-performance. 

For quality, it is important to look for companies with above-average sustainable growth and profitability—and strong free-cash flow generation.  It is also important to focus on return on assets, rather than return on equity, since the latter can be boosted by debt. Additionally, it is important to prefer companies with conservative balance sheets.

The simplest solution for investors wanting to embrace higher quality, smaller cap value stocks, is to buy a low-cost exchange-traded fund which invest small company, higher quality “value” stocks.  BlackRock offers the iShares Core S&P Small-Cap ETF (IJR), with a low expense ratio of 0.07% and Vanguard offers Small-Cap Value ETF (VBR), with a low expense ratio of 0.07%.

One of Wall Street secret: Investors can make good money with the stocks of smaller companies whose names aren’t necessarily household words.

In the long run, small-cap value is the undisputed champion of the major asset classes such as large cap growth. But the operative phrase there is “in the long run.” Over shorter time periods, small-cap value stocks can be disappointing and significantly trail asset classes such as large cap growth.


References:

  1. https://www.marketwatch.com/story/a-strategy-to-outsmart-the-sp-500-bubble-2020-08-20?mod=mw_quote_news
  2. https://www.marketwatch.com/articles/a-tale-of-two-indexes-1516896321
  3. Fama, Eugene F. and French, Kenneth R., A Five-Factor Asset Pricing Model (September 2014). Fama-Miller Working Paper, Available at SSRN: https://ssrn.com/abstract=2287202 or http://dx.doi.org/10.2139/ssrn.2287202
  4. https://www.marketwatch.com/story/buy-the-best-performing-stock-sector-for-87-years-2015-03-11
  5. https://www.marketwatch.com/story/youre-loving-high-flying-growth-stocks-now-but-your-money-should-be-in-these-companies-this-market-pro-says-2020-08-20
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