Yesterday’s post on LSV Asset Management’s performance reminded me of the practical difficulties of implementing many theoretically well-performed investment strategies. LSV Asset Management is an outgrowth of the research conducted by Josef Lakonishok, Andrei Shleifer, and Robert Vishny. They are perhaps best known for the Contrarian Investment, Extrapolation, and Risk paper, which, among other things, analyzed low price-to-book value stocks in deciles (an approach possibly suggested by Roger Ibbotson’s study Decile Portfolios of the New York Stock Exchange, 1967 – 1984). They found that low price-to-book value stocks out perform, and in rank order (the cheapest decile outperforms the next cheapest decile and so on). The problem with the approach is that the lowest price-to-book value deciles – that is, the cheapest and therefore best performed deciles – are uninvestable.
In an earlier post, Walking the talk: Applying back-tested investment strategies in practice, I noted that Aswath Damodaran, a Professor of Finance at the Stern School of Business, has a thesis that “transaction costs” – broadly defined to include brokerage commissions, spread and the “price impact” of trading – foil in the real world investment strategies that beat the market in back-tests. Damodaran made the point that even well-researched, back-tested, market-beating strategies underperform in practice:
Most of these beat-the-market approaches, and especially the well researched ones, are backed up by evidence from back testing, where the approach is tried on historical data and found to deliver “excess returns”. Ergo, a money making strategy is born.. books are written.. mutual funds are created.
…
The average active portfolio manager, who I assume is the primary user of these can’t-miss strategies does not beat the market and delivers about 1-1.5% less than the index. That number has remained surprisingly stable over the last four decades and has persisted through bull and bear markets. Worse, this under performance cannot be attributed to “bad” portfolio mangers who drag the average down, since there is very little consistency in performance. Winners this year are just as likely to be losers next year…
Damodaran’s solution for why some market-beating strategies that work on paper fail in the real world is transaction costs. But it’s not the only reason. Some strategies are simply impossible to implement, and LSV’s low decile price-to-book value strategy is one such strategy.
James P. O’Shaughnessy’s What works on Wall Street is one of my favorite books on investing. In the book, O’Shaughnessy suggests another problem with the real-world application of LSV’s decile approach:
Most academic studies of market capitalization sort stocks by deciles (10 percent) and review how an investment in each fares over time. The studies are nearly unanimous in their findings that small stocks (those in the lowest four deciles) do significantly better than large ones. We too have found tremendous returns from tiny stocks.
So far so good. So what’s the problem?
The glaring problem with this method, when used with the Compustat database, is that it’s virtually impossible to buy the stocks that account for the performance advantage of small capitalization strategies. Table 4-9 illustrates the problem. On December 31, 2003, approximately 8,178 stocks in the active Compustat database had both year-end prices and a number for common shares outstanding. If we sorted the database by decile, each decile would be made up of 818 stocks. As Table 4-9 shows, market capitalization doesn’t get past $150 million until you get to decile 6. The top market capitalization in the fourth decile is $61 million, a number far too small to allow widespread buying of those stocks.
A market capitalization of $2 million – the cheapest and best-performed decile – is uninvestable. This leads O’Shaughnessy to make the point that “micro-cap stock returns are an illusion”:
The only way to achieve these stellar returns is to invest only a few million dollars in over 2,000 stocks. Precious few investors can do that. The stocks are far too small for a mutual fund to buy and far too numerous for an individual to tackle. So there they sit, tantalizingly out of reach of nearly everyone. What’s more, even if you could spread $2,000,000 over 2,000 names, the bid–ask spread would eat you alive.
Even a small investor will struggle to buy enough stock in the 3rd or 4th deciles, which encompass stocks with market capitalizations below $26 million and $61 million respectively. These are not, therefore, institutional-grade strategies. Says O’Shaughnessy:
This presents an interesting paradox: Small-cap mutual funds justify their investments using academic research that shows small stocks outperforming large ones, yet the funds themselves cannot buy the stocks that provide the lion’s share of performance because of a lack of trading liquidity.
A review of the Morningstar Mutual Fund database proves this. On December 31, 2003, the median market capitalization of the 1,215 mutual funds in Morningstar’s all equity, small-cap category was $967 million. That’s right between decile 7 and 8 from the Compustat universe—hardly small.
The good news is, there are other strategies that do work.
[…] the leverage can be a problem. There are other problems with cheap book value. As I discussed in The Small Cap Paradox: A problem with LSV’s Contrarian Investment, Extrapolation, and Risk in prac…, the low price-to-book decile is very small. James P. O’Shaughnessy discusses this issue in What […]
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[…] The Small Cap Paradox: A problem with LSV’s Contrarian Investment, Extrapolation, and Risk in pra… […]
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This is precisely the advantage of the small investor.
My investment universe contains 1,000’s more stocks than a fund manager could plausibly invest in.
In addition to having more choices, this also means that I don’t have to compete against the professionals. I only have to compete against people like the readers of this blog :P
About 1/3 of my equity holdings are micro caps right now, with market caps of:
$6 million
$16 million
$21 million
$25 million
$58 million
$94 million
So none in the 1st decile, but several in the 2nd-4th.
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[…] October 27, 2010 by greenbackd As I mentioned yesterday, James P. O’Shaughnessy’s What works on Wall Street is one of my favorite books on investing. The thing that I like most about the book is O’Shaughnessy use of data to slaughter several sacred value investing cows, one of which I mentioned yesterday (see The Small Cap Paradox: A problem with LSV’s Contrarian Investment, Extrapolation, and Risk in prac…). […]
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I think that your readers divided into deciles by investable assets would show that most of them, with limit orders and patience, could utilize a small/micro/nano cap strategy.
And a slight ironic twist, one stock I’m thinking of is Hennessy (HNNA), which is a mutual fund manager with $900 AUM and trades at less than 1% EV/AUM, which is low. They have mediocre fund performance, but are well managed at a corporate level. One of their main funds was an acquisition that used to be called the O’Shaughnessy such and such fund. Up until recently, all of but now most of, their funds are managed based on formulas such as those mentioned above. Hennessy outperformed in the bull market, but got clobbered in the bear market (which I think is also useful to think of in formula investing since when you rebalance is important but only known in hindsight).
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What are these other strategies that do work? I tried implementing a low price to book and low debt to equity mechanical investment strategy this year, and the bid ask spread ate me alive as O’Shaughnessy said. With a portfolio of 30 stocks, I did not have time to make and keep track of separate limit orders for each stock. So instead I have built a portfolio of 20 stocks that have positive FCF for the last ten years, good margins, grew FCF more than 3% a year, and are cheap according to DCF with a 12% discount rate. For growth rates I used the CAGR from the most recent 3 year average FCF to the 8 year ago average 3 year FCF, and averaged it with the consensus analyst estimate for 5 year growth rate. So far it has exactly matched the sp500 in returns for the year.
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O’Shaughnessy calls price-to-sales the “King of the value factors”. That might be a good place to start.
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