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In theory, an investment strategy with a focus on small cap and value stocks should result in returns superior to the major market indexes. After all, smaller companies have greater flexibility to respond to opportunity or adversity and their growth runway is much longer once they have a winning product or service. Plus, a screen for value should reduce the negative impact of torpedo stocks that can unexpectedly blow a hole in the portfolio return.

So much for the theory. The reality for the past decade is that both of these factors have been a drag on portfolio returns. In Canada, for the 10 years ended Dec. 1, the big cap dominated S&P/TSX Composite Index has delivered an annual total return of 5.9 per cent, while the S&P/TSX SmallCap Index total return has been 1.3 per cent over the same period. There are multiple definitions of value and growth, but as an example, the Dow Jones Canada Select Growth Index has a 10-year return of 6.7 per cent, while the comparable Canada Select Value Index return is a percentage point lower at 5.7 per cent.

Investors may argue that the nature of value has evolved over the past few years as intangible assets dominate a service economy, so the old bricks-and-mortar definitions no longer capture economic value creation. As a result, we should not be surprised if traditional value screens produce a list of underperforming stocks. The failure of small-cap stocks to deliver superior returns is more difficult to explain, so I was quick to read an article titled “Has the Size Premium Disappeared?” by noted investing author and researcher Larry Swedroe in the Nov. 30 issue of Advisor Perspectives. His article is essentially a review of the literature dating back to 1981 right through to September, 2020. Although most of the research refers to the U.S. stock market, it is reasonable to assume there are lessons for Canadian investors.

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His opening sentence is pretty discouraging for small-cap investors: “Small-cap stocks have underperformed the broader markets since the ‘discovery’ of the size premium in 1981.” According to his statistics, from 1982 through August, 2020, (almost 40 years) large-cap stocks have returned 11.8 per cent a year, while small caps delivered 11.3 per cent a year.

Digging deeper into the statistics over more recent time frames, academic researchers profiled in the article agree on a couple of observations.

First, the original small-cap premium was probably overstated to some extent because the riskiness (volatility) of small caps is often underestimated owing to the fact that they are illiquid and trade infrequently. After correcting for this understatement, the risk-adjusted premium remains, but it is much reduced.

Second, the small-cap universe contains a large number of “lottery” stocks that drag down the return for the overall universe. (I wrote about some of these on June 2.) These are stocks where the expected payoff for the group is below average, but investors buy them anyway because they hope to own one of the few with a huge payoff.

A number of researchers tested this lottery stock effect by creating small-cap portfolios with a focus on quality. More specifically, they created quality minus junk (QMJ) portfolios and found that a significant small-cap premium re-emerged that was stable over time, not confined to microcaps and applicable across nearly two dozen international equity markets. In other words, a small-cap quality portfolio rather than a small-cap value portfolio might address the performance shortfall of the past decade.

To test this hypothesis in the Canadian context, I returned to the S&P/TSX small cap indexes. In addition to the S&P/TSX SmallCap, there is another parallel index called the S&P/TSX SmallCap Select. According to the S&P Global website, this subset of the Canadian small-cap index was specifically created to respond to U.S. and Canadian research that showed “small-cap companies without a track record of generating earnings have performed poorly relative to their profitable peers and have thus been a drag on broad small-cap indices.” Exactly in line with the Swedroe article.

To eliminate the junk, the SmallCap Select Index eliminates the 20 per cent smallest and 20 per cent least liquid companies and also requires that every company must post two consecutive years of positive earnings for every share. Two consecutive years of negative earnings and you are dropped from the index. There are obviously many other criteria of quality, but this seems like a reasonable starting point. So what is the recent experience in Canada?

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We already know that the 10-year SmallCap annual return was 1.3 per cent to Dec. 1. For this entire period, the Select Index delivered in line with expectations with an annual return of 4.2 per cent. This is good, although still below the 5.9 per cent of the big-cap S&P/TSX Composite, so even quality Canadian small caps failed to deliver a premium to the market. Also, as we shorten the time frames, the differential in favour of quality eventually disappears: The all-embracing index is 50 basis points ahead of the Select over five years, a percentage point ahead over three years and more than 10 percentage points ahead over the latest year, with a return of 13.5 per cent versus 3.3 per cent for the Select Index.

What can we learn of practical value from all this academic research? My initial reaction is that you can torture the data until they confess to crimes they never committed. If you mine a big database long enough with different beginning and ending dates, all kinds of spurious correlations will pop up. Also, very few academic research studies take transaction costs into account and the illiquidity of most small-cap stocks means that few institutional investors can exploit even persistent valuation anomalies.

More relevant to the Canadian situation is the fact our small-cap universe is not a microcosm of the larger index, but is very heavily skewed toward the resource and energy sector and away from the financial and interest-sensitive elements of the S&P/TSX Composite. As a result, what may appear to be a small-cap versus large-cap phenomenon at first glance is in fact a junior resource versus financials play.

My recommendation to small-cap investors is to build a portfolio around quality and value and then set aside a small amount of money specifically for those lottery stocks that are irrational but irresistible.

Robert Tattersall, CFA, is co-founder of the Saxon family of mutual funds and the retired chief investment officer of Mackenzie Investments.

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