Bear Market Lessons: The Advantage of Micro-Caps

    by James B. Cloonan

    The bear market of the last two years has hurt many investors, but it has hurt some much more than others. In general, it has hurt institutional investors and individuals who have institutions managing their money more than it has hurt individual investors who manage their own money—unless the individual failed to diversify.

    The reason individuals fared better during this bear market has to do with the way individuals invest and the types of securities in which they can invest. The recent market has emphasized the importance of many of the long-term principles of successful investing.

    Once again, the advantage of micro-cap stocks has been demonstrated. Micro-caps are defined here as the stocks of companies with market capitalizations (share price times number of shares outstanding) below $125 million. In 2000, the Beginner’s Portfolio, AAII’s experimental portfolio of micro-cap stocks, was down 7.9% but the S&P 500 was down 11.1%, a 3.2% advantage. In 2001, the Beginner’s Portfolio was up 30.5% and the S&P 500 was down 12%, a 42.5% advantage. And after two months this year, the Beginner’s Portfolio has an advantage of 6%. [The Beginner’s Portfolio was started nine years ago to show that a consistent approach could be followed without great time requirements, and to examine the problems and procedures of managing a portfolio of micro-cap stocks. A complete description of the Beginner’s Portfolio, including the rules and past performance, appeared most recently in the August 2001 issue of the AAII Journal.]

    I am not suggesting that individuals should have all of their equity investments in micro-cap stocks. While they do outperform the general market in the long run, there are periods when they underperform larger-cap stocks. The nine full years we have been running the Beginner’s Portfolio has been a weaker-than-average period for micro-cap stocks, but they still outperformed the market. Table 1 presents a summary of the performance over the last nine years. The table includes data on the S&P 500 for comparison, and it also shows the performance of a diversified portfolio (Portfolio X) that is 50% invested in the S&P 500 and 50% in the Beginner’s Portfolio.

    Table 1. The Beginner's Portfolio: A Performance Summary
      Beginner's Portfolio S&P 500 Portfolio X**
    Compound Annual Return (over 9 yrs) 13.6% 13.1% 13.9%
    Terminal Value of $10,000 (end of 9 yrs) $31,470 $30,360 $32,350
    Standard Deviation* (over 9 years) 18.2 % 17.2% 13.7%

    The Effect of Volatility

    As you can see, there is not a lot of difference between the Beginner’s Portfolio and the S&P 500. A very important lesson comes, however, from examining Portfolio X. While about the same in average annual returns, this portfolio had lower risk in terms of volatility, as measured by standard deviation, a figure that shows how much actual returns varied around the average. Table 1 also shows that $10,000 invested initially in Portfolio X would have grown about 3% more than the Beginner’s Portfolio.

    Portfolio X illustrates the real advantage of diversification. Not only is the volatility lower so you sleep better, but you may also wind up with greater terminal wealth.

    How can this be—less stress and higher returns? Table 2 illustrates how this can occur. The simple average return for all three investments is the same over the time period covered. However, terminal wealth isn’t based on simple averages; instead, returns compound over time and volatility affects the results. Investment A produced steady returns year after year; Investment B was more volatile than Investment A, and Investment C produced the most volatile returns. Yet Investment A produced the most terminal wealth at the end of the period and had the highest compounded return. Portfolio X in our first table is a perfect example of the advantages of diversifying across market capitalizations. If maintaining the equivalent of the S&P 500 and the Beginner’s Portfolio is too time-consuming, almost the same results can be achieved by investing 50% in the Vanguard, Fidelity or Schwab S&P 500 index funds and 50% in a diversified micro-cap mutual fund.

    Table 2. The Impact of Volatility
      Average Annual Return Terminal Wealth of $10,000
    Year 1 (%) Year 2 (%) Year 3 (%) Year 4 (%)
    Investment A 10 10 10 10 14,640
    Investment B 0 20 0 20 14,400
    Investment C 30 -10 30 -10 14,690

    The Effect of Weightings

    Another lesson to be learned from the last several years of market performance is that there is a weakness in index funds. Virtually all indexes are capitalization-weighted—in other words, the proportion of a stock represented in the index is based on its market capitalization, with the largest capitalization companies represented much more heavily in the index than stocks with lesser market capitalizations. This means that, although you may think you are getting a portfolio diversified over 500 or 2,000 stocks (depending on the index), the index is only moderately diversified because so much of the index is in the 10 or 20 largest companies.

    In Table 1, you can see that the standard deviation of the Beginner’s Portfolio, a 20-stock portfolio, is only slightly higher than that of the S&P 500. This capitalization weighting not only reduces the implied diversification, but it weights index portfolios toward larger-cap stocks, even though the historical evidence suggests that the smaller the capitalization of a company, the more likely it will produce higher stock returns.

    Here is an example of how the weightings affected what happened in 2001:

    • The S&P 500 index, which is market-capitalization-weighted, was down 11.88%, but a portfolio of the 500 stocks equally weighted would have been up 1.63%.

    • The Nasdaq composite index, which is market-capitalization-weighted, was down 20.13%, but those same stocks bought in equal dollar amounts would have been up 63.86%. That seems incredible, but remember almost all the losses on the Nasdaq were in the high-capitalization tech stocks. In contrast, micro-cap stocks had a banner year.
    This is the reason many individual investors were not hurt as badly as institutions over the last several years. They bought more small-cap stocks and they tend to invest equal amounts in each holding.

    The past two years have been more extreme due to the collapse of technology stocks and the ridiculous capitalizations these stocks had at the top of the market. But even in the long run, smaller is better. And to avoid volatility in the shorter term, diversify across capitalizations.

    Bear Market Lessons

    I don’t know why there is not an unweighted S&P 500 index fund. An equally weighted Russell 2000 or Nasdaq index would not be practical because the smaller-cap stocks in these indexes are too small for institutional buying.

    It is important, however, for individual investors to own micro-cap and small-cap stocks (usually defined as companies with market capitalizations between $125 million and $1 billion). This is becoming more difficult: Many of the micro-cap mutual funds are closing to new investors because their increasing asset sizes make it difficult to invest in the smaller companies.

    If there is a good side at all to a bear market period, it is to drive home basic investment principles. Unfortunately, many of us who are older learn the lesson a little late, when there is less investment time left to take advantage of the lesson.

    James B. Cloonan is chairman of AAII.

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