By Michael J. Corbett
Ever since financial markets materialized, investors have been devising schemes to enable them to beat the market’s average return. Some invest in large companies, some invest in small companies, and others ignore company size and invest in companies of any size so long as they have potential to produce excess returns. Some investors buy-and-hold, while others trade frenetically. Some invest in high multiple growth stocks, while others prefer to shop among companies whose stocks have recently been beaten down. Then there are the technical analysts and those who analyze only economic fundamentals. Some investors assemble portfolios from “the top down,” while others prefer a “bottom up” approach.
Academics have long admonished investors for spending so much time trying to predict the future. They point to the plethora of studies that indicate the stock market is a reasonably efficient mechanism. In an efficient market, the best guess at tomorrow’s stock price is today’s price. Most academics agree that the only way to produce market-topping long-term investment returns is to build and maintain a highly-diversified portfolio that contains more systematic risk than the stock market as a whole. In short, what investors ultimately get from their equity portfolios is paid for by the risks they take.
The first formidable crack in the so-called efficient market theory appeared in the late 1970s when a University of Chicago doctoral student discovered a strategy that has produced superior investment returns for more than 80 years. Superior meaning that this strategy has historically produced greater returns than dictated by portfolio risk. This strategy has come to be known as “the small firm effect.” Simply put, the small firm effect is the tendency of the common stocks of small firms to outperform the common stocks of large firms given the same level of risk. According to Ibbotson & Associates, small company stocks have produced annualized returns of 11.44% from 1926 through 2015, which compares favorably to large company stock’s return 10.02%. Even when returns are measured over shorter time periods, smaller company stocks perform well versus other assets classes. The table above shows the performance of Large Company Stocks, Small Company Stocks, Long Term Government Bonds and Treasury Bills for each of the past eight decades. While small company stocks have not always been the best, there returns are meaningfully positive in every period.
Due to these performance results and the academic research, I have dedicated my life and career to following and investing in smaller company stocks. My near 30-year career has brought me both satisfaction and handsome results, but various changes in the past 15 years has me pondering the future of small company stocks. The changes in the past 15 year are mostly related to increased regulation and the cost of being a public company. Much of the changes started with Sarbanes Oxley Act (SOX) passed by U.S. Congress in 2002, which is designed to reduce the risk of fraudulent activities by corporations. While the act had lofty goals, the cost was too prohibitive, particularly for smaller companies. There have been several other laws and programs introduced after SOX was passed in 2002. Another example is Dodd-Frank, which significantly increased banking regulations and costs. The bottom line is that we believe these increased regulations resulted in less publicly traded companies. As you can see from the chart above, the number of U.S. companies listed on the major exchanges has declined from more than 7,000 to less than 3,600 today.
In addition to companies that are not interested in having their equity publicly traded, merger and acquisition activity also contributed to the decline of publicly traded companies. Furthermore, we believe it is partially obvious that only quality companies are routinely acquired, and that lower quality companies do not get acquired. The point is that as this dynamic increases the percent of lower quality companies within the public markets today.
With regard to low quality companies, the table below details some interesting history for the Russell 2000 Index and the Russell Microcap Index. As you can see, the number of profitable companies has declined significantly in the past 10 years while the number of unprofitable companies has increased significantly. While the universe of publicly traded companies is starting to be dominated by low quality companies, we believe the situation may change in the next few years.
Donald Trump’s election as president of the United States and the Republicans’ sweep of control in the legislation caught the financial world off guard. So, what does a Trump presidency mean for the markets and the economy? The implications of how a Trump win plays out in the markets are not entirely obvious. Trump has not been overly detailed on his economic policies and there is always a transition from campaign rhetoric to actual policy. However, it does seem clear that there will be a push for fewer regulations and lower taxes. Whether regulations are modified or not and taxes are reduced or not, it seems clear that the future may have a more pro-business orientation. Therefore, this new environment could pave the road for more companies wishing to becoming public companies. Remember that not all companies go public through the traditional method of an IPO. You could also see new companies coming public from spin-offs, reverse mergers, or moving from the pink and bulletin board market to the national exchange. The next few years should be an exciting time to find and invest in new quality smaller public companies.
Source Ibbotson & Associates:
Large Company Stocks defined as S&P 500
Small Company Stock defined as CRSP 6-8 decile
MICHAEL CORBETT, CEO, CIO and Portfolio Manager
Michael is CIO and Portfolio Manager for all equity portfolios with Perritt Capital Management and The Perritt Funds. Perritt Capital Management first employed Mr. Corbett in 1990 as a research analyst. He assumed portfolio management responsibilities in 1996. In late 1999, Mr. Corbett became president and lead-manager of the Perritt MicroCap Opportunities Fund (PRCGX). He became portfolio manager of the Perritt Ultra MicroCap Fund (PREOX) at its inception in 2004 and the Perritt Low Priced Stock Fund (PLOWX) at its inception in 2012. Mr. Corbett was named to the Barron’s/Value Line Top 100 Mutual Fund Manager from 2003-2007. He is a Registered Investment Advisor. Mr. Corbett’s insight regarding small company investing has been sought after by a variety of financial media outlets, including CNBC and The New York Times. He is a member of the Joliet Diocese Endowment Fund Board and previously served on the St. Mary Gostyn Finance Committee and the St. Mary Gostyn School Board.
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