The "Small Company Effect" - that is, the tendency
of "smaller" listed companies to outperform the
"market" - was first reported in 1978 by Rolf Banz.
Banz collated data on stocks listed on the New York Stock
Exchange from 1931 to 1974. In each of those 43 years he divided
the stockmarket into five portfolios based upon the market
capitalisation of each company (i.e. the first portfolio
"owned" the largest 20% of all listed shares, the last
portfolio owned the 20% of companies that were the smallest).
Over the 43 years of this test, Banz found that the portfolio
that held the largest companies under-performed the market by
1.3% per year, while the "smallest" companies
outperformed the market by 5.5%.
In 1982, Professors Thomas Cook and Michael Rozeff repeated that
testing on over 3000 stocks listed on the NYSE, AMEX and
"over the counter" markets between 1968 and 1978. They
divided shares into ten groups (based upon each company's
stockmarket capitalisation) - and discovered similar results: The
largest 10% of companies under-performed by 4.2% per year, while
the 10% of "smallest" shares outperformed by 5.4% per
year.
James O'Shaughnessy's recent work (for his book "What Works
on Wall Street") found similar results for the 43 year
period from 1951-1994. O'Shaughnessy found that "large
stocks" (i.e. approximately the largest 10% of companies)
and "mid-cap" stocks (i.e. approximately the second
largest 10% of companies) under-performed by about 2.7% per year
while "micro-cap" stocks (i.e. with capitalisations
below US$25 million, or approximately the "smallest"
30% of listed shares) outperformed the market by 10.4% per year!
In "Stocks for the Long Run", Professor Jeremy Siegel
writes that the small company effect "is positive in every
country where it has been tested and quite significant in most of
them". However he also notes that this effect "waxes
and wanes" over time. For example, much of the excess
performance of smaller companies in the US occurred between 1975
and 1983 (when these shares "boomed") and
"smaller" shares can involve higher transaction costs
(owing to a wider spread between the bid and offer prices
quoted).
Investment Implications: Younger investors (who have a long term
investment "horizon" and who can afford to take some
extra risk) should invest part of their portfolio in some of the
"smallest" companies listed on the sharemarket. Older
investors (seeking to minimise risk) should aim to invest in
shares below the top 10-20% by size as these offer better returns
than the very largest listed companies.
The first study of "neglected", or
"unpopular", shares was published in 1964 by Professor
Scott Bauman.
Between 1954 and 1961 he constructed a portfolio of 30
"popular" stocks (being the most widely owned stocks
from a survey of 80 large mutual funds) and a "less
popular" portfolio of stocks held by only one or two of
these funds.
Over the eight year period the "popular" portfolio
under-performed the market by 2.7% while the "less
popular" portfolio outperformed by 0.9%.
In 1982, Professor Avner Arbell and Paul Strebel published the
results of their study of 500 NYSE listed companies for five
years from 1972-1976. They divided these shares into three
(approximately equal) groups based upon the number of
sharebrokers' analysts preparing profit forecasts.
The group of stocks that was most widely researched was found to
have under-performed the market by 4.6%, while the group of least
researched stocks outperformed by 6.5%.
This sample was also broken down by company size to see if the
"small company effect" was causing these results. That
is, to see if the least researched stocks were of
"smaller" companies and if the "smaller company
effect" was producing these results.
This showed that "neglect" was dominant over the
"small company effect" but also that
"neglected" and "smaller" companies yielded
the highest investment returns (i.e. the "least
researched" among the "smallest" 50% of stocks
yielded the highest returns).
A year later these Professors published another study of 510
NYSE, AMEX and "over the counter" stocks over a
ten-year period from 1971-1980. Returns were measured based upon
market capitalisations and institutional ownership (i.e. the
stocks were divided into three groups, with the
"neglected" stocks held by only one institution or by
none).
The most "widely owned" stocks under-performed by 5.8%
per year and the "neglected" stocks outperformed the
market by 5.6% per year.
Splitting the results by size showed that "neglect"
dominated the "small firm effect" - suggesting that the
"small firm effect" may be caused by
"neglect".
Investment Implications: All research into stocks
"neglected" by sharebrokers and/or
"neglected" by institutions shows superior returns for
"neglected" shares and inferior returns by "widely
followed" and "widely owned" shares.
All investors should therefore seek to own shares that are
"neglected" by brokers and have few (or no)
institutional shareholders - while avoiding companies
"followed" by many brokers and where many institutions
already hold significant shareholdings.
We are not aware of any published research that proves that a
large shareholding by management is "good" for the
company's investment performance.
However, this idea is intuitively attractive. If management have
a large stake in the company, then their interests will co-incide
with those of the public minority shareholders.
In addition, the very smallest listed companies tend to have
large management shareholdings (and the very largest companies
have a negligible percentage of their capital held by
management). The positive impact of a large management
shareholding may therefore be the cause of the superior returns
earned by "smaller" companies (i.e. the "small
company effect).
Investment Implications: While we cannot quantify the importance
of a large management shareholding, we would rather invest in a
company where the CEO's financial interest is a million dollar
(or ten million dollar) shareholding than a company where the
CEO's financial interest is limited to a million dollar salary
package.
One of the first studies of the Price/Earnings ratio and
investment returns was published in 1960 by Francis Nicholson.
This study covered 100 large stocks in each of four periods of
five-years (i.e. twenty years in total). Stocks were ranked by
P/E ratio and divided into five portfolios. Overall the highest
P/E ratio portfolio (i.e. the most "over-valued")
under-performed the market by 1.8% per year while the lowest P/E
ratio portfolio (i.e. the most "under-valued")
outperformed by 4.7% per year.
A study published in 1977 by Professor Sanjoy Basu, covering 1400
stocks for fifteen years from 1956-1971, yielded almost identical
results with the high P/E ratio portfolio under-performing by
2.8% per year and the lowest P/E portfolio outperforming by 4.2%
per year.
Later work examining these results broken down by company size
revealed that (1) high P/E shares under-performed regardless of
company size and (2) "small" companies with low P/E
ratios outperformed the market very strongly.
This result is contradicted in the recent study by James
O'Shaughnessy (for the 43 year period from 1951-1994 mentioned
previously) which found that a portfolio of the fifty highest P/E
stocks - selected from the whole market - underperformed by 4.0%
per year, but that the portfolio of fifty stocks with the lowest
P/E ratios also under-performed by 1.3%.
The P/E ratio only "worked" successfully when applied
to "larger" companies. Here the portfolio of the
highest fifty P/E shares under-performed by 2.0% while the
portfolio of the fifty lowest P/E shares outperformed by 1.9%.
O'Shaughnessy's study suggests that the Dividend Yield is also a
valuable selection criteria but only when applied to the
"larger" companies. This is similar to Michael
O'Higgins method (published in "Beating The Dow") of
buying the ten highest yielding stocks (or alternatively buying
the five lowest priced of these ten highest yield stocks) from
the Dow Jones Average of 30 stocks of large companies.
A high yield usually indicates a low share price (as a company is
"out of favour" or experiencing some
"problems"). Large - and financially strong - companies
can survive these "problems" (so are good investments),
whereas a "smaller" company experiencing
"problems" may well fail.
O'Shaughnessy's study suggests that the Price/Sales ratio is the
most reliable "fundamental" statistic. His low P/S
ratio portfolio selected from the whole market outperformed by
3.0% per year, while the high P/S ratio portfolio under-performed
by an extremely significant 8.3%!!!
Applied to only "larger" stocks, the low P/S ratio
portfolio outperformed by 2.3% per year, while the high P/S ratio
portfolio under-performed by 2.1% per year.
Investment Implications: There are some contradictory results
relating to "smaller" companies trading at low
Price/Earnings ratios and high Dividend Yields, but the
Price/Sales ratio appears to be a very useful statistic - for
both "larger" and "smaller" companies.
All investors should seek low P/S, low P/E and high Yielding
shares, while avoiding high P/S, high P/E and low Yielding
shares.
Buying by "insiders" (i.e. directors and senior
management) and Share Re-purchases (i.e. where a company buys
back its own shares on the market) are widely considered to be
favourable. Knowledgeable "insiders" are the best
placed to know what a share is really worth.
An early study by Professor Shannon Pratt and Charles DeVere
monitored 52,000 "insider" trades in 800 NYSE stocks in
the seven years from 1960 to 1966. A "buy" signal was
considered to have occurred when three "insiders"
bought shares within one month, while three sellers within a
month constituted a "sell" signal.
Stocks with "insider" buying were found to outperform
shares with "insider" selling for up to three years
after the "insider" transactions. The "buy"
group had risen an average of 59.1%, while the "sell"
group was up only 27.1%. The buy group steadily outperformed the
sell group throughout the first 24 months after the
"insider" signals - with both groups showing
approximately similar rates of appreciation during the third
year.
There are two main ways a company can re-purchase its shares:
(1) a Tender Offer - where the company offers to buy a fixed
number of shares at an above market price. Shareholders can
tender their shares to the company, which can scale back
acceptances if investors offer more shares than it is seeking.
(2) an On-Market Buy-back - where the company instructs its
broker to buy back its shares on the sharemarket over a period of
time.
Early research on share re-purchasing - a 1980 study by Larry
Dann of 143 tender offers between 1962 and 1976, and another 1980
study by Theo Vermaelen of 131 tender offers from 1962 to 1977 -
indicated shares subject to buy-backs did not perform well.
Immediately that a tender was announced, stocks rose (by an
average of 15%), but did not continue to outperform the market
during the following 60 days.
A study by Fortune in 1985 examined 187 buy-backs from 1974 to
1983. From the end of the month of their buy-back through to
December 1983 these stocks outperformed the market by 9% per
year.
Where the shares were re-purchased in a tender offer the stocks
outperformed by 6% per year (following the completion of the
buy-back), while stocks subject to on-market purchases
outperformed by 10% per year.
Another magazine, Forbes, published a study in 1987 which found
that 126 companies re-purchasing their own stock (between 1983
and 1986) outperformed the market by an average of 24% (i.e.
about 8% per year).
In 1990 Professor Josef Lakonishok and Theo Vermaelen published
another study that examined 258 repurchases made between 1962 and
1986 by all listed US companies. On average these companies
offered to buy back 17% of their capital, at a 22% premium to the
market and around 85% of shares tendered by investors were
accepted.
As observed in the earlier studies, the stock price immediately
jumped (by an average of 14%) following the announcement of the
buy-back, then only equalled the "market" over the next
three months. However, from three months through to 24 months
after the buy back was announced the stock outperformed the
market by 23% (i.e. about 13% per year).
The study found that the "smaller" the company, the
better the performance during this 3-24 months after the
re-purchase announcement. Typically, "smaller"
companies' shares had been falling sharply for three years prior
to the share re-purchase - and their subsequent two year rally
dwarfed that of the shares of "larger" companies!
Investment Implications: "Insider" buying and selling
by directors is not disclosed in NZ - but this information is
available in Australia. Certainly investors should tend to favour
Australian shares where several "insiders" have
purchased shares during the last year.
Share re-purchases are relatively rare, but can lead to excellent
investment returns over the following couple of years -
especially among the very "smallest" companies!
In 1967, Robert Levy published a study of Relative Strength
Analysis. Each week for the five years from 1960 to 1965 he
ranked 200 NYSE shares by the percentage amount that the current
price was above or below its average price for the previous 26
weeks (i.e. he compared the current share price to its "26
week moving average").
A strategy of buying shares in the top 10% and selling when they
fell out of the top 80% outperformed the market by about 9% per
year.
Another strategy - buying shares in the top 5% and selling when
they fell from the top 70% - outperformed by about 15% per year.
Norman Fosback's 1976 book, "Stock Market Logic",
included the results of his research into Relative Strength on
over 750 AMEX listed stocks over an eight year period from 1963
to 1971. Fosback calculated a "strength rating" - being
the percentage change in a stock's 30-week moving average over
the previous thirteen weeks (i.e. the 13-week change in the
30-week moving average).
Ranked by their strength rating, and divided into five equal
groups, the "strongest" shares outperformed by 5.1% per
year, while the "weakest" shares underperformed by 5.6%
per year.
O'Shaughnessy's recent work (which measured relative strength
simply as the percentage change in a stock's price over the
previous 12 months) confirms the predictive value of Relative
Strength.
The "strongest" shares (from the whole market)
outperformed by only 1.5% per year, but the "weakest"
shares underperformed by 10.7% per year.
Selecting from only "larger" companies, the
"strongest" shares outperformed by 5.1% per year while
the "weakest" shares under-performed by 2.3% per year.
O'Shaughnessy also found that relative strength significantly
improved results in multi-factor selection methods.
Investment Implications: There is a tendency for share prices to
move in "trends". So investors should generally buy
into (and, more importantly, hold onto) shares that are rising in
price. Similarly investors should generally avoid buying into
companies whose share prices are falling rapidly.
Next month, in the final of this series on Share Selection
Methods, we shall use the information presented above to
subjectively formulate a comprehensive Share Selection Criteria.
Although the selection and weighting of the indicators will
require subjective judgement, all of the share selection methods
we have discussed involve objective numbers that can be
calculated using a formula (e.g. the P/S ratio, or a Relative
Strength Rating) or by direct observation (e.g. counting up the
number of "insiders" buying or selling over the last
year).
Securities Research Company maintains computerised databases of
all listed NZ companies and all listed Australian companies, so
by writing a program to match the comprehensive share selection
criteria we shall be able to produce a selection of possible
"buy" candidates and a selection of shares that
possibly should be sold.