The Problem With Small-Cap Value Indexes

Part I: Indexing Idiocy

MSCI’s value index (MGV, VTV) is seriously lagging behind the USA index (EUSA, PBUS). Its ten-year, five-year, three-year, and one-year CAGRs are all lower. The small-cap index (PBSM) is still ahead if you look at its ten-year CAGR, but way behind on its five-year, three-year, and one-year numbers. And MSCI’s small-cap value index (VBR) has been utterly pitiful: its one-year return as of the end of January was 8.94%, compared to 25.54% for the USA index; its ten-year, five-year, and three-year numbers are also really low. All this has prompted remarks among some investors that the advantages of value and small-caps seem to be vanishing.

This all seems like nonsense to me. Value disappearing? Small caps not doing well? I invest only in low-priced small caps and microcaps, and I made 45% in 2016 and 58% in 2017.

Here’s what’s actually going on: not much has really changed.

If you define “value,” as MSCI does, as a combination of low price-to-book, low P/E, and high dividend yield, you’re defining value all wrong. The price-to-book ratio is one of the worst value ratios you can come up with, since it rewards companies with little to no leverage rather than companies that are using their leverage wisely (I’ve written at length about this here). High dividend yield is only a good thing if the company isn’t paying out more than it takes in (I’ve written at length about this here).

And MSCI isn’t the worst offender at all.

Read the fine print as to how Russell defines its value indexes (IUSV, IWD, IWN, IWS, IWX, OVLU, PXLV, PXMV, PXSV, VONV, VTWV). It creates a three-pronged ranking system. Fifty percent is based on the terrible price-to-book ratio. The other fifty percent is made up of a medium-term growth forecast and the company’s five-year-historical sales growth per share, but ranked negatively, so that the companies with least growth potential get ranked the highest. It’s almost as if they’ve designed the index to fail. And, sure enough, it has. Total returns of the Russell 2000 Value index, as of the end of January, are seriously lagging the Russell 3000 by every single measure from one month to ten years.

I’ll admit, there are some smarter value indexes out there. MSCI, to its credit, has its “Enhanced Value Index” (IVLU), which combines price to book and price to forward earnings with enterprise value to cash flow from operations, and rebalances twice yearly. Sure enough, this index beats their other value indices pretty consistently. But its one-year and three-year record still lags behind their USA index, and it only includes mid- and large caps.

I know I’m committing heresy here, but I’m going to come out and say it: most factor-indexed ETFs are based on idiocy. I can’t understand why anyone would want to invest in, say, SLYV (S&P 600 small-cap value). This is an ETF that rebalances annually (exactly the wrong approach for small-cap value, though it makes sense for large-cap value), defines small-cap as less than $2.1 billion (thus including a huge number of mid-caps), and defines “value” by looking only at equity measures and ignoring all enterprise-value-based measures, as well as ignoring all quality measures. That’s not what value investing is. Well, I guess it is now, but it never was until the rise of all these senseless indexes. Value investing involves serious consideration of a lot of fundamentals, not just three common equity-based measures.

OK, this brings up the basic question: what exactly is value investing? As Michael Mauboussin of Blue Mountain puts it, “There has been a simplistic association between value investing and the basic idea of buying statistically cheap stocks.” And that’s not what value investing really is. “At its core, value investing is buying something for less than what it’s worth.” And what it’s worth can’t be determined by a simplistic statistical approach. You can’t just look at a few price ratios and say, “This is a value stock.” You need to look at a stock’s fundamentals from many different angles. “If you do not have the time or inclination to seek value . . . indexing is a reasonable path.” I would say it’s perhaps the only reasonable path. But just don’t call it “value.”

I find indexing essential. I need to have an index to compare my results with. I can’t do regression analysis without an index. I have no beef with people who want to use a value index to analyze their investment strategy. Indexing is a very useful tool.

But using an index as a tool and investing in it are two very different things. Indexing is fantastic for investors who don’t want to spend the time and energy finding mispriced stocks and figuring out when to buy and sell them. It’s cheap, it’s easy, and it works wonders. Just don’t call it value investing.

Small-cap value investing works, always has worked, and always will work. You just have to work extremely hard at it rather than relying on an index.

Part II: A Better Small-Cap Value Index

Now the difference between investing in small caps and large caps is very simple, and consists of two things. First, large caps are more stable, they’re safer, they’re solid, they don’t jump around like mad. Second, almost all sensibly built (i.e. top decile a lot better than bottom decile) ranking systems based on fundamentals will perform better (i.e. larger difference between top and bottom decile) in a small-cap or microcap universe than in a large-cap universe.

To illustrate this, I’ve created, using Portfolio123, a very simple ranking system based on the three factors in the MSCI enhanced value index, equally weighted. Here’s how it performed in four different universes with a minimum price of $3.00 and a quarterly rebalance since 1999. As you can see, the smaller the capitalization, the bigger the difference in performance.

Indexing idiocy

Now I’m going to go a step further. I’m going to create what I would consider an ideal small-cap value index, again using Portfolio123. I’m going to use eight factors, equally weighted (and I’m not going to tell you what they are unless you pay me big bucks). Four of them are based on the price or enterprise value of the stock, three on its quality and/or growth, and one on its size. This index tracks the 500 top-ranked stocks with market caps greater than $100 million and prices greater than $1.00, with a quarterly rebalance. It does include a few large caps, but it’s equally weighted, so companies with a market cap of over $10 billion only make up about 7% of the index.

This index beats all the others hands down. Since January 2000, with slippage costs of 0.5% each time stocks are bought and sold, it has made a CAGR of 19.27%, compared to SPY’s 5.42%. If you had invested in this index beginning in Y2K, you would have earned almost fifteen times what you would have earned if you’d invested in SPY. This index beat SPY in fourteen out of the last eighteen calendar years, and was within 4% of SPY in seventeen (2011 was a badyear for it).

Of course, hindsight is 20/20, and I doubt I would have come up with this system back in 1999. But regardless, if you’re a fan of factor index investing, it pays to combine lots of factors in one index. And that’s an increasing trend these days. A slew of multifactor ETFs have come out in the last few years, and that’s a very good thing as long as the factors are transparent and sensible and the fees are low.

But why diversify to five hundred stocks? I know that’s what indexing is all about, but it’s really not essential. If I invest in only the top fifty ranked stocks rather than the top five hundred, the standard deviation of my “index” goes up 15% or 20%, but the returns go up to 27.59% annually, meaning that you would have earned fifty times as much as SPY over the last eighteen years.

So, as you can see, I still believe that a dedicated, systematic small-cap value investing strategy is the best strategy to follow. Which is why it’s such a shame that many of the so-called small-cap value ETFs are misleading investors into putting their money into stocks that are set up to fail.

CAGR since 1/1/15: 49%

My top ten holdings right now: SBFG, CTG, WSTL, BCML, ACNB, RCMT, UWN, PFSW, QTRH, FWP.

Disclosure: None.

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