Small Stocks Are The Winnder, But Not By Much

I look at two additional distinct groups of stocks-Small Stock, or stocks that have market capitalizations greater than a deflated$185 million but less than the database average, and Market Leaders. Market leaders are like Large Stocks on steroids. They come from the Large Stocks unvierse but also prosses characteristics beyond mere size. To be a market leading company, you must be a nonutility stock with a market capitalization greater than the average, shares outstnading greater than the average, cashflow greater than the average, and finally, sales 50 percent greater than the average stock. Apply these factors to the overall Compustat database leaves just 6 percent of the database qualifying as Market Leaders.

If we ignore the micro-cap stocks as unobtainable, the results show that investors who pay no heed to risk or other factors are best off concertrating on smaller stocks from the Compustat database. As we’ll see later, this is appropriate only for investors who want to make market capiatalization the sole criterion for stock selection. These resutls confirm the academic studies showing smaller stocks beating large stocks, but once micro-caps are removed, by not nearly the large margins that many studies have found. What’s really fascinating is the performace of the stocks with capitalizatiions between $500 million and $1 billion. They perform nearly the same as Large Stocks and considerably worse than All Stocks, Small Stocks, and Market Leaders. This contradicts the belief that, belife that , simply because a stock is in the smaller category, it offers the greaterst potential to investors.

Ironically, we have found that when you use strategies like those featured that are looking for maximum return, they inevitably lead you to stocks in the small and mid-cap category. I believe this is not because of market capitalization alone, but rather because the stocks in this category are the least efficiently priced. Currently, around 400 stocks account for approximately 75 percent of the U.S. stock market capitalization, whereas literally thousands of stocks make up the remaining 25 percent. The sheer number of names in the small and mid-cap category makes them far more difficult for analysts to adequately cover, providing great opportunities to investors willing to use a systematic, disciplined approach to finding those name that possess the factors that have a long association with higher return.

Written by James P. O’Shaughnessy

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