Small Cap Quality Stocks: The Gift from the Index Fund Complex

Our team believes in inefficient markets, behavioral finance, empirical evidence, and common sense. Having penned brutally simple pieces explaining the risks large cap, large cap growth, and small cap index fund owners are taking, our recent exchange with an advocate of index funds was inevitable. The caller was upset.

In our piece on small-cap index funds, we explained that almost 40% of the stocks in the portfolio couldn’t turn a profit during one of the most benign fiscal and credit environments in history – a record. The angry voice on the other side of the phone explained that, according to efficient markets, these loss-making companies would provide higher returns in exchange for their higher risk.

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Apparently, they missed the chart showing that is empirically false, so we countered with common sense:

“If you had to choose a portfolio of 100 companies that earned money or 100 companies that lost money, which would you want to own?” The response was predictable. “Well, when you put it that way, obviously I’d buy the profitable ones.” Dogma like that allows us to build charts like the one below.

Small Cap PE Ratios: An Earnings Yield Spread to Remember

KCR has produced a simple, low-turnover small-cap model portfolio since shortly after our firm’s founding in 2010. The chart below shows the earnings yield of our small-cap portfolio minus the earnings yield of the Russell 2500.^[1] Last week’s brief video explained why active small-cap investing strategies are crucial today.

In many ways, the chart below further validates that work. Our elegant, rules-based strategy has a portfolio of stocks with an earnings yield advantage of 8% over the broad range of small-cap companies you’d end up owning in an index fund. As this piece explains, for patient capital, active management has never looked better and less complicated than today.

We quintiled our Small-Cap Portfolio by its earnings yield advantage vs. the index over the last 40 years. The chart below shows the median value spread by quintile of our portfolio from the least value-advantaged time periods (first bar) to the most advantaged time periods (last bar on the right).

Looking at the right-most bar, you can see that when our portfolio is in the cheapest quintile relative to the broader market small-cap index, we have a 6.4% advantage.

Look back at the prior chart. Our portfolio today has an ~8% advantage. One of the widest readings in our model’s history.

Investing in our model portfolio at these points in time has historically generated very high batting averages vs. the index. The three sets of bars below show the following:

• First two bars: If you just bought our model portfolio and held it for 12 months every time its earnings yield was in the top quintile, you beat the index 77.05% of the time by an average of 14.4%

• Second two bars: when our yield advantage was in the top quintile and the market went up over the next 12 months, you won 77.14% of the time by an average of 13.2%

• Last two bars: when our yield advantage was in the top quintile and the market fell over the next 12 months, you won 76.92% of the time by 16.1%

KCR is fond of the saying, “roughly right is better than precisely wrong,” and if you’re wondering about the two-decimal “precision” in the chart below – we apologize. We did that only because of the odd coincidence that the batting average was roughly 77% in all three scenarios that made it harder to write to!

The simple charts above show that as the lemmings herd into index funds, the distortions in small-cap stock prices have exploded. Last week, we put out a 15-minute video explaining the in-depth case for why we believe active small-cap investing strategies have never been more important than today.

But for long-term investors, it has rarely been as simple, in our view. The table below shows the fundamentals of KCR’s Small Cap portfolio vs. the Russell 2500. What’s remarkable in our mind is that our portfolio is an expression of just how irrational the market’s pricing structure is. Our stocks trade at a massive discount to the index yet have higher ROEs, pay enormous yields and are still growing at a healthy ~10% a year (35%, 3-year sales growth).

The less you pay, the more you get.

As the recent 2018-2020 bubble taught us, there are people who will pay to lend insolvent governments money (negative yielding bonds), financial alchemy can temporarily run-riot (crypto “yield harvesting”) and stocks with zero empirical basis for existing can somehow achieve market caps that dwarf large-cap blue-chips (Carvana’s Investor Relations decks being a great example).

And this is one of the reasons the KCR team believes the cheap beta of index funds is valuable.^[2] But advocates of indexing at the exclusion of sentient, evidence-based investment strategies strike us as dangerous dogma. And as the share prices of small-cap stocks in the Russell 2000 Index and Russell 2500 Index are increasingly driven by flows rather than fundamentals, it has created enormous dispersion within the index.

We understand the obsession over interest rates and the potential for a Fed pivot, and what it might mean for stocks. Yet we doubt anyone can predict such things with any consistency and prefer the idiosyncratic over the systematic. The former can be researched and understood, while the latter strikes us as a more speculative endeavor.

What we like so much about active management in small-cap funds today is that their managers can invest in small-cap stocks with significant margins of safety. We are not suggesting these high-quality firms are immune from broad bear markets. Yet historical data suggests they carry some of the greatest statistical advantages for investors through a full market cycle.

For access to our monthly Small-Cap Portfolio’s monthly picks, please click here.