In 1939, Sir John Templeton borrowed $10,000 and used it to invest $100 inevery stock listed on NYSE selling for under $1. In all, he purchased 104 different stocks. No regard was paid to the quality of the business, profits, etc. In fact, 37 out of these 104 companies were already in bankruptcy.

3 years later, Sir John had profits in 100 out of the 104 stocks he had purchased.

Templeton of course is a legendary value investor who believed in investing at the point of maximum pessimism. The above investment was made at the start of World War 2. A contrarian to the bone, he explained his investing philosophy with some humor simply as "help people". When people are desperate to sell, help them by buying. When people are desperate to buy, help them by selling.

The Rise and Disappearance of the Size Premium

In 1981, it was discovered that the small-cap stocks in the US have higher average return than large stocks, the difference not explainable by the market beta. This size premium was characterized with irregularities such as its relative absence in international markets, concentration of returns in January, and low statistical significance. Further studies came to conclusions that the size premium essentially disappeared soon after the original discovery was made. This of course is the perennial problem in modern finance - as soon as a pattern emerges that offers significant advantages in expected returns, everyone rushes to cash in, and therefore this advantage disappears.

If Sir John Templeton were to repeat his $100 investment in 100 worst stocks strategy after 1980s, it would not have worked.

There is a theory which states that if ever anyone discovers exactly what the Universe is for and why it is here, it will instantly disappear and be replaced by something even more bizarre and inexplicable.

There is another theory, which states that this has already happened.

- Douglas Adams, The Hitchhiker's Guide to Galaxy

Controlling for the Junk

In a recent draft paper titled "Size Matters, If You Control Your Junk"¹ (good to see these academics and Wall Street guys having fun with the headline), the authors argue that the Size Premium is alive and well if we focus on quality companies. What is more, the variance between returns of the small quality stocks and large quality stocks is more pronounced than thought, and it holds across geographies and consistent over the course of the year (the returns are no longer concentrated in January).

In short, small quality stocks outperform large quality stocks, small junky stocks outperform large junky stocks, and quality outperforms junk. The key to understand why the studies have shown inconsistent results is that small stocks tend to be loaded with junk companies while large stocks tend to be primarily quality companies.

Keep in mind the following:

• Junk is defined as inverse-quality, and,
• quality is deduced based on these indicators - profitability, profit growth, low risk in terms of return-based measures and stability of earnings, and high payout and/or conservative investment policy, and therefore can be measured and analyzed.

How Do These Findings Affect Your Investments?

In a way, this paper aims to provide a theoretical basis for something that even if it was not formally explained, it was at least implicitly understood by most sophisticated investors. Consider the rise of activist investors in the past few decades. Activism relies on replacing the "junkiness" in a company with quality and then captures the upside. Most other investors that may not be able to buy a voice in the board room should focus on the quality attributes even while seeking outstanding valuations.

Thinking of buying a small-cap value index fund or ETF? Don't bother - they are full of junk and give you no particular advantage in the long run. You may receive some positive alpha over market index from time to time, but the long run will not be as kind to your portfolio. The only way to get quality in your small-cap portfolio is to find actively-managed fund with an experienced manager running it.

Note: I normally use P/E, P/B and other similar ratios for screens, but not for the actual valuations (in some cases, they are appropriate, and in others, they are not). When you use these ratios to screen for potential ideas and consciously discard the stocks that have negative values for these ratios, you tweak your sample towards higher quality/less junk as you emphasize profits or some other fundamental measures of quality.

For investors in small-cap companies, there is no substitute for deep due diligence.

Value Investing and Junk

Ben Graham is famous for shunning management contact in the companies that he invested in. In fact, he would only go by the numbers and data. Warren Buffett on the other hand pays a lot of attention to the intangibles such as quality of the management, market position of the company, moat, etc. Arguably. Buffett is constrained by the amount of capital he has at his disposal, so small quality stocks are hard for him to invest in. However, he did start out by investing in cigar butt stocks, which are by definition junk. Over the years, value investors have continued to invest in "situations," and quality tends to be an afterthought.

It is important to remember though that these studies are done with large samples, and as a result, they tend to paper over individual stock picking skills. After all, every stock is a buy at a sufficiently low valuation.

¹Asness, Clifford S. and Frazzini, Andrea and Israel, Ronen and Moskowitz, Tobias J. and Pedersen, Lasse Heje, Size Matters, If You Control Your Junk (January 22, 2015). Fama-Miller Working Paper. Available at SSRN.