Investing in Micro Cap Stocks

Microcap Millionaires

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Microcap Millionaires Summary


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Mutual Funds An Investment

I know that, but please bear with me. I don't want to make the mistake that I see so many investment writers (and financial advisors) make starting with the more advanced stuff on the assumption that you know the basics. So often I hear from people reading about mutual funds and complaining that a writer starts throwing around terms such as small cap value stock fund and asset allocation without explaining them, and before you know it, you're lost in the weeds and frustrated. You have every right to be. Mutual fund terms, such as municipal bond fund or small cap stock fund, are thrown around too casually. Fact is, thanks to our spending-oriented culture, the average American knows cars a lot better than mutual funds. In this chapter and the next, I explain the investment and mutual fund terms and concepts that many writers assume you already know (or perhaps don't understand well enough themselves to explain to you).

Practical Applications For Financial Planners

Given that index management has outperformed active management in most U.S. asset classes, financial planners can use index funds to improve their clients' pre-tax and after-tax performance, in addition to lowering portfolio expenses. (Please see Table 2.7, which contains the average expense ratios for the U.S. Large-Cap, Mid-Cap, Small-Cap, International Large-Cap and International Mid Small-Cap asset classes.) For example, while the average expense ratio in the actively managed Large-Cap Blend asset class is 1.35 percent, diversified index funds managed by high-quality organizations can be accessed with expense ratios as little as .09 percent. Financial planners with clients in higher marginal tax brackets may also find that tax-managed index funds or separate accounts are attractive alternatives. While tax-managed index funds and separate accounts typically possess higher investment minimums (for example, 10,000- 1 million) as well as modestly higher expense ratios than typical...

Portfolio Completion and Risk Management

For example, an investor may have a large number of restricted shares in the semiconductor industry. In that situation, the person may want to short shares of the SPDR S&P Semiconductor (XSD). That would reduce one's overall risk exposure to a downturn in that sector. XSD is an equal-weighted market cap index of semiconductor stocks listed on the NYSE, American Stock Exchange, NASDAQ National Market, and NASDAQ Small Cap exchanges.

Finding the Minimum Variance Portfolio

Historically, the return of the S&P 500 Index (S&P) has had a correlation of .8 with the return of the Dimensional Fund Advisors small cap fund, which is a portfolio of small stocks that trade mostly on Nasdaq. S&P has a standard deviation of 20 percent per year that is, ctg&p .2. The DFA small cap stock return has a standard deviation of 39 percent per year that is, adfa .39. What portfolio allocation between these two investments minimizes variance Example 4.18 implies that a short position in the DFA small cap fund reduces variance relative to a portfolio with a 100 percent position in the S&P. Indeed, until we reach the 132 percent investment position in the S&P index, additional shorting of the DFA fund to finance the more than 100 percent position in the S&P index reduces variance. For example, consider what happens to the variance of a portfolio that is 100 percent invested in the S&P 500 when its weights are changed slightly. Increase the position to 101 percent invested in...

An Example of a Passive Selection Family

Frank Russell & Company of Tacoma, Washington, created the Russell family of passively selected stock indexes in 1984. Russell calculates the value of 21 indexes daily. Almost all Russell indexes are subsets of the Russell 3000 Index, which represents approximately 98 percent of the investable free-float U.S. equity market. The one exception is the Russell Micro Cap index, which stretches below the Russell 3000. The smallest 1,000 stocks in the Russell 2000 plus the next 1,000 smallest stocks below the Russell 2000 become the Russell Micro Cap index. 2,000 Micro Cap 2,000 Micro Cap

Figure 82 Russell Index Security Selection

The iShares Russell Micro Cap ETF (symbol IWC) is bench-marked to the passively selected Russell Micro Cap index. It cannot be fully replicated in an actual portfolio because many of the smallest 1,000 stocks in the index do not have enough liquidity. Although the Russell Micro Cap index has 2,000 stocks, IWC is composed of only about 1,200 liquid stocks sampled from the index.

Trends in Small Cap Stock Returns

Although the historical return on small stocks has outpaced large stocks since 1926, the magnitude of the small-cap stock outperformance has waxed and waned unpredictably over the past 80 years. A comparison of the cumulative returns on small stocks with those of the S&P 500 Index is shown in Figure 9-1.9 9 The small-cap stock index is the bottom quintile (20 percent) size of the NYSE stocks until 1981, then it is the performance of Dimensional Fund Advisors (DFA) Small Company fund from 1982 through 2000, and then it is the Russell 2000 Index from 2001 onward.

Asset Allocation An Investment Recipe

You may hear a mutual fund nerd spout off about his allocation between large-cap and small-cap stocks, or between growth funds and value funds. Don't worry about these terms for now (for the nerd in you, you'll be happy to know that I cover these other fund subcategories in Chapter 9). Even after you finish reading this book and become a mutual fund hotshot, you should be mostly concerned with the general asset allocation decisions namely, allocating between stocks and bonds, and between U.S. stocks and international stocks.

The Trade Off between Risk and Return

The table accompanying this box summarizes the historical trade-off between risk and return for different classes of investments from 1926 through 2000. As the table shows, those assets that produced the highest average returns also had the highest standard deviations and the widest ranges of returns. For example, small-company stocks had the highest average annual return, 17.3 percent, but their standard deviation of returns, 33.4 percent, was also the highest. By contrast, U.S. Treasury bills had the lowest standard deviation, 3.2 percent, but they also had the lowest average return, 3.9 percent.

Structuring Portfolios

Second, the investor has to choose within each asset class the categories of securities in which to invest. For stocks, the categories may be large-cap stocks, small-cap value stocks, and so on. For bonds, these may be short-term bonds, long-term bonds, foreign bonds, and so on. The investor then must decide what percentage of his allocation to each asset class he wants to allocate to each category within that class.

Using Capital Market History

From Table 12.3, we see that the risk premium on large-company stocks has been 9.1 percent historically, so a reasonable estimate of our required return would be this premium plus the T-bill rate, 3.5 + 9.1 12.6 . This may strike you as being high, but, if we were thinking of starting a new business, then the risks of doing so might resemble those of investing in small-company stocks. In this case, the historical risk premium is 13.4 percent, so we might require as much as 16.9 percent from such an investment at a minimum. The term growth stock is frequently used as a euphemism for small-company stock. Are such investments suitable for widows and orphans Before answering, you should consider the historical volatility. For example, from the historical record, what is the approximate probability that you will actually lose more than 16 percent of your money in a single year if you buy a portfolio of stocks of such companies Looking back at Figure 12.10, we see that the average return on...

Holding Period Returns

Before looking closely at the different portfolio returns, we graphically present the returns and risks available from U.S. capital markets in the 74-year period from 1926 to 1999. Figure 9.4 shows the growth of 1 invested at the beginning of 1926. Notice that the vertical axis is logarithmic, so that equal distances measure the same number of percentage changes. The figure shows that if 1 were invested in common stocks and all dividends were reinvested, the dollar would have grown to 2,845.63 by the end of 1999. The biggest growth was in the small-stock portfolio. If 1 were invested in small stocks in 1926, the investment would have grown to 6,640.79. However, when you look carefully at Figure 9.4, you can see great variability in the returns on small stocks, especially in the earlier part of the period. A dollar in long-term government bonds was very stable as compared with a dollar in common stocks. Figures 9.5 to 9.8 plot each year-to-year percentage return as a vertical bar drawn...

Russell US Equity Indexes

In 1984, Frank Russell & Company created the Russell family of stock indexes to measure the performance of active managers. Today several hundred billion dollars are benchmarked to Russell's stock indexes, and some of that money is invested in ETFs. The most popular ETF is the iShare Russell 2000, which follows an index of small cap stocks. The Russell 3000 Index measures the performance of the 3,000 largest U.S. companies based on total market capitalization, which represents approximately 98 percent of the investable U.S. equity market. There are several tiers of Russell indexes, and all are subsets of the Russell 3000 Index with the exception of the Russell Micro Cap index, which extends from stock number 2,001 down to stock number 4,000. See Chapter 8 for a detailed explanation and illustration of the Russell U.S. equity index family hierarchy.

Morgan Stanley Capital International Indexes MSCI

MSCI's investable market is composed of three market capitalization segments large cap, mid cap, and small cap. The company defines Large Cap Index as the 300 largest companies by full market capitalization in the investable market segment. The Mid Cap Index comprises the next 450 companies and the Small Cap Index consists of the remaining 1,750 companies. The large cap and the mid cap indexes are also combined to create a separate index of the 750 largest companies in the investable market segment, as ranked by full market capitalization.

Think Global Invest Global

Furthermore, many overseas ETFs are becoming more specialized in subsectors with diverse issues focused on value, small-cap, and dividend models, for example. Therefore investing overseas is becoming like that in the United States with nearly as many different approaches there as in the United States.

How Do Etfs Work In Risk Management Applications

Existing ETFs are all based on benchmark indices. While there are important benchmarks and there are unimportant benchmarks, benchmark index derivatives are widely used in risk management applications. For example, an investor with an actively managed small-cap portfolio might feel that superior stock selection reflected in the portfolio will provide good, relative returns over the period ahead, but that most small-cap stocks might still perform poorly. The investor can hedge the portfolio's exposure to small-caps while capturing its stock selection advantage by hedging the small-cap risk with a short position in a financial instrument linked to the Russell 2000 small-cap benchmark index. Available risk management tools for this application range from futures contracts and equity swap agreements to the shares of a small-cap exchange-traded fund.

From Huge Dow to Micro

Everyone recognizes the Dow Jones Industrial Average, but few people have heard of the Dow Jones Select Micro Cap Index. It measures the performance of very small stocks trading on major U.S. exchanges. Dow Jones represents the index as the investable portion of U.S. micro cap companies because there is believed to be liquidity in those stocks. The DJ Select Micro Cap Index is a custom benchmark. Issues with the smallest market capitalizations and lowest trading volumes are excluded, although the customization categorization is due to fundamental screening. Companies with poor fundamentals are filtered out. The screens exclude stocks with poor operating profit margins, inadequate price-to-earnings ratios, price-to-sales ratios, earnings momentum, and relative performance versus other micro caps.

Building the Model

Enter formulas to calculate the values of the investments for each year Start by entering 1 in G30 I30. To calculate the investment value at the beginning of 1983 for small-cap stocks, in G31 enter the formula G30*(1+B30). Now copy the formula into H31 and I31 and then copy G31 I31 into all the rows down to row number 51. Even though your data ends in 2002, your table needs to extend to 2003 because that row represents the values of the investment for the beginning of 2003 (equivalent to the end of 2002). 3. Calculate the average annual returns To calculate the average annual return for the small-cap index, in G24 enter the formula (G51 G30)a(1 21)-1. Note that the period 1982-2002 covers 21 years, not 20. Copy the formula into H24 and I24.

Uses of the Model

As you can see both from the table and the chart, this type of analysis provides a very compelling comparison of the behavior of the different asset classes over time. For example, it is clear that despite all the ups and downs in the individual years, large-cap stocks provide an excellent return over the period a 1 investment grew to 13.35 by the end of the period. Small-cap stocks and bonds closely matched each other, but both trailed large-cap stocks.

Markowitz meanvariance portfolios are suboptimal

As an example of the performance improvement achievable with the 4 a optimal portfolio approach, we computed the 4 a efficient frontier and the mean-variance frontier for a portfolio of 47 micro-cap stocks with the smallest alphas from the random selection of 182 micro-caps described above. The results are displayed in Figure 17. The results are based on 3,000 scenarios from the fitted 4 a multivariate distribution model based on two years of daily data during years 2000 and 2001. We note that, as is generally the case, each of the 47 stock returns has its own estimate Stable tail index ai,i 1, 2, , 47. We note that the 47 micro-caps with the smallest alphas used for this example have quite heavy tails as indicated by the boxplot of their estimated alphas, shown in Figure 18. RETURN VERSUS RISK OF MICRO-CAP PORTFOLIOS Daily Returns of 47 Micro-Caps 2000-2001 47 MICRO-CAPS WITH SMALLEST ALPHAS Here the median of the estimated alphas is 1.38, while the upper and lower quartiles are 1.43...

Broad International and Global Market Indexes

MSCI Standard indexes target 85 percent of the free-float adjusted market cap segment of the global equity markets. The size cutoff varies somewhat across countries and regions depending on the extent of the market. To cover most of the other 15 percent, MSCI Small Cap indexes are promoted by the firm as ''exhaustively covering'' the investable small cap market worldwide. The data include both developed and emerging markets. In total, MSCI has created more than 20,000 style, sector, and regional indexes worldwide. That leaves no shortage of indexes to use as future benchmarks for ETFs. The FTSE All-World Index Series was launched in 1987. It provides a single set of ground rules that are applied to FTSE Global Equity Index Series (Large, Mid, and Small Cap), the FTSE All-World Index Series (Large and Mid Cap), and the FTSE Global Small Cap Indexes.

The Super Guide to Investing

The term growth stock is frequently a euphemism for small-company stock Are such investments suitable foj widows and orphans Before answering, you should consider the historical volatility For example, from the historical record, what is the approximate probability that you wiil actually lose 16 percent or more of your money in a single year If you buy a portfolio of such companies7

Corporate Income Taxes

13Fifty percent of any capital gains on the newly issued stock of certain small companies is excluded from taxation, provided the small-company stock is held for five years or longer. The remaining 50 percent of the gain is taxed at a rate of 20 percent for most taxpayers. Thus, if one bought newly issued stock from a qualifying small company and held it for at least five years, any capital gains would be taxed at a maximum rate of10 percent for most taxpayers. This provision was designed to help small businesses attract equity capital.

Four Analysts Cover The Stock Of Fluorine Chemical. One Forecasts A 5 Return For The Coming Year

Your portfolio has three asset classes. U.S. government T-biUs account for 45 of the portfolio, large-company stocks constitute another 40 , and small-company stocks make up the remaining 15 . If the expected returns are 3.8 for the T-bills, 12.3 for the large-company stocks, and 17.4 for the small-company stocks, what is the expected return of the portfolio

The following information relates to Questions 1922 The Level I exam uses only independent questions This minicase is

Boris Duarte, CFA, covers initial public offerings for Zellweger Analytics, an independent research firm specializing in global small-cap equities. He has been asked to evaluate the upcoming new issue of TagOn, a U.S.-based business intelligence software company. The industry has grown at 26 percent per year for the previous three years. Large companies dominate the market, but sizable pure-play companies such as Relevant, Ltd., ABJ, Inc., and Opus Software Pvt. Ltd also compete. Each of these competitors is domiciled in a different country, but they all have shares of stock that trade on the U.S. NASDAQ. The debt ratio of the industry has risen slightly in recent years.

The Historical Record

This is a portfolio composed of stock of smaller companies, where small corresponds to the smallest 20 percent of the companies listed on the New York Stock Exchange, again as measured by market value of outstanding stock. Looking at Figure 10.4. we see that the small-company, or small-cap (short for small-capitalization), investment did the best overall. Every dollar invested grew to a remarkable SI 5,922.43 over the 81 years. The larger common stock portfolio did less well a dollar invested in it grew to 3,077.33. Given the historical record, why would anybody buy anything other than small cap stocks If you look closely at Figure I0.4, you will probably see the answer. The T-bill portfolio and the long-term government bond portfolio grew more slowly than did the stock portfolios, but they also grew much more steadily. The small stocks ended up on top, but, as you can see, they grew quite erratically at times. For example, the small stocks were the worst...

How to Determine Your Equity Style in the Selection of Individual Stocks

Should you rush to buy the small-capitalized stocks that have been responsible for the major moves in the Russell 200 Index Or should you look for value stocks and technology stocks that have been hit in the downturn of the stock market (Dow Jones Industrial Average and the NASDAQ Composite) in the years 2001-2002 Related to this issue are the sizes of the companies. The rally has included the small-capitalization stocks while the mid-cap and large-cap stocks have been excluded, although small-capitalization stocks were also down in the early months of 2002. Small capitalization less than 1 billion Medium capitalization 1- 5 billion Large capitalization greater than 5 billion studies have measured stocks by their market capitalization, or size, which was then translated into small-cap, mid-cap, and large-cap stocks. Figure 32.1 lists the categories based on market capitalization of the companies, which is measured by the number of shares outstanding for the company multiplied by the...

Private Equity Within A Diversified Portfolio

Equity with that of several asset classes.8 Using information reported by Warburg, Pincus, they find that the correlation of private equity returns with that of corporate and Treasury bonds to be 10 and 7 , respectively. With the S&P 500 and small cap stocks, the correlation with private equity returns was 60 and 68 , respectively. However, when Gompers and Lerner adjust the Warburg, Pincus private equity returns with estimated marks to market, they find that the correlations with corporate bonds, Treasury bonds, large cap stocks, and small cap stocks, increases to 19 , 14 , 74 , and 78 , respectively. Nonetheless, the less than perfect correlation of private equity with major asset classes indicates it has useful properties of diversification.

Building a Diversified Portfolio with Private Equity

To determine whether private equity investments add value to a diversified portfolio, we maximize portfolio value over five asset classes large-capitalization stocks, small-capitalization stocks, investment-grade bonds, cash, and private equity. For large-cap stocks we use the S&P 500 total return index, for small-cap stocks we use the NASDAQ total return index, for long-term bonds we use the Salomon Smith Barney Broad Investment Grade (BIG) Bond Index, and for cash we use the 3-month U.S. Treasury bill rate. private equity compared to the traditional stock and bond asset classes.13 For instance, the returns to all four classes of private equity are negatively correlated with investment-grade bonds and U.S. Treasury bills, and have low correlation with the returns to large-cap and small-cap stocks. In conclusion, the less than perfect correlation (and, in some cases, negative correlation) of private equity returns with the returns to stocks, bonds, and cash indicate excellent...

Real estate investment trust funds

W _ w REITs are small-company stocks and usually pay decent dividends. As such, they are not appropriate for higher-tax-bracket investors investing money outside of retirement accounts. Most of the larger, diversified U.S. stock funds that I recommend earlier in this chapter have a small portion of their fund's assets invested in REITs, so you'll have some exposure to this sector with investing in a REIT focused fund.

Analyzing Private Equity within a Portfolio Context

A constrained optimization program is run to solve the equation at each level of risk aversion.16 In Exhibit 11 we present the base case of maximizing utility without using any class of private equity. We can see that a risk neutral investor allocates her entire portfolio to small-cap stocks. This is because the risk-neutral investor is not encumbered by concerns over risk maximizing return is all that matters. An investor who is unconcerned with risk will not have her behavior affected by the volatilities or correlations of the various asset classes. This type of investor invests in the asset class that yields the highest expected returns small-capitalization stocks. However, as the investor's level of risk aversion increases, we see that she diversifies her portfolio between small-cap stocks and the less volatile investment-grade bonds. The reason is that these asset classes have less than perfect correlation with each other. By diversifying across a number of asset classes, the...

Application Closedend funds and comovement

A second behavioral view of comovement was recently proposed by Barberis and Shleifer (2003). They argue that to simplify the portfolio allocation process, many investors first group stocks into categories such as small-cap stocks or automotive industry stocks, and then allocate funds across these various categories. If these categories are also adopted by noise traders, then as these traders move funds from

The Dollar And Large Caps

Another intermarket relationship involves how the dollar affects large and small cap stocks. Large multinational stocks can be negatively impacted by a very strong dollar, which may make their products too expensive in foreign markets. By contrast, the more domestically oriented small cap stocks are less affected by dollar movements and may actually do better than larger stocks in a strong dollar environment. As a result, a stronger dollar may favor smaller stocks (like those in the Russell 2000), while a weaker dollar may benefit the large multinationals (like those in the Dow Industrial Average.)

Intermarket Analysis And Mutual Funds

It should be obvious that some understanding of these intermarket relationships can go a long way in mutual fund investing. The direction of the U.S. dollar, for example, might influence your commitment to small cap funds versus large cap funds. It may also help determine how much money you might want to commit to gold or natural resource funds. The availability of so many sector-oriented mutual funds actually complicates the decision of which ones to emphasize at any given time. That task is made a good deal easier by comparing the relative performance of the futures markets and the various stock market sectors and industry groups. That is easily accomplished by a simple charting approach called relative strength analysis.

Foreign Stocks Carry Highest Expense Ratios

There is a significant variance in the expense ratios by investment option category. The average expense on an international small-cap fund, for instance, is 122 basis points (see Exhibit 5.10). For fixed-income investments, however, money markets carry an average expense ratio of 42 basis points, stable value 37 basis points, and domestic bonds either 62 basis points (for active funds) or 34 basis points (for passive funds). Domestic equity investments also carry varying average fees, with small-cap the highest at 103 basis points and large-cap the lowest at 78 basis points. U.S. equity index funds have an average expense ratio of just 31 basis points, according to the survey.

Comparing Market Averages

The first thing that is clear is that the Dow Industrials was the only market average to gain on the day. On all the TV news programs that night, investors were told that the market (represented by the Dow) was up for the day. Yet all the other measures were actually down. Notice also that the broader the average (the more stocks included) the worse it did. Compare the percentage changes. The 30 stock Dow gained .16 . The S&P 500 lost .07 . The Nasdaq Composite, which includes more than 5,000 stocks, was the day's worst performer and lost .92 . Almost as bad as the Nasdaq was the Russell 2000 (-.89 ), which is a measure of 2000 small cap stocks. The message in this brief comparison is that even though the Dow gained on the day, the overall market lost ground as measured by the more broader based stock averages. We'll revisit the idea of comparing market averages again. But first, let's show the different ways market technicians can analyze the market's breadth numbers.

Objectives Are They Compatible with Your Level of Risk

The objectives and policies of the fund generally appear near the front of the prospectus. The objectives describe the type of securities the fund invests in as well as the risk factors associated with the securities. For instance, if the prospectus states that the fund will buy growth securities, the investor should not be surprised to find that most of the stocks will have high price-earnings ratios and may include risky small-cap stocks.

Intangible Analysis of Sectors and Industries

Depending on the economic climate, either large caps, medium caps, small caps, or micro caps will drive the stock market's performance. On Tuesday, December 30, 2003, the following data were collected. Tables 8.2 and 8.2a are more easily understood on a relative basis. We know, from our preceding discussion of the intangible analysis of a single market, that indices are typically made up of large cap firms and medium cap firms. Small cap and micro cap firms are absent from index analysis (Tables 8.3 and 8.3a). Micro Cap Small Cap

Equity Index Investing

In the United States, the public equity market is so large that a number of different indices have been constructed to capture different parts of the stock market. For example, the S&P 500 is designed to track the largest capitalized stocks in the United States. Conversely, the Russell 1000 and 2000 are designed to track large, mid, and small cap stocks. Last, the Wilshire 5000 is designed to capture the full public equity market in the United States. The size and growth of equity index investing has distinct implications for corporate governance programs.

Lowest Relative Return

ANALYZING SMALL CAPS On the 30th of December, 2003, there were 1500 large caps out of a total of 8103 firms (18.51 ). In Tables 8.9 and 8.9a, it is assumed that an investor has 1,500,000 to invest in shares. As the investor is unaware of what shares will increase in value, the investor invests 1,000 in each small cap stock. TABLE 8.9 intMgtOS Small Cap Report (intMgtOS 5003.iR23a) TABLE 8.9 intMgtOS Small Cap Report (intMgtOS 5003.iR23a) Small Cap TABLE 8.9a intMgtOS Small Cap Report

Weakest Relative Returns

Micro caps outperformed the two weakest large cap sectors by an average of 200.97 . However, small caps (56.12 ) outperformed micro caps (53.96 ) by 3.83 (Table 8.14). In general, in 2002-2003 small caps performed best. Intangible value has a positive dimension (+IV) and negative dimension (-IV). When intangible value is negative, it means that the book value of the firm is greater than the market value of the firm. Enron is a good example. As of December 30, 2003, the company had negative intangible value of 7,416.73 m and a market value of 22.32 m (making it a small cap firm). In this case, a company supposedly worth nearly 8 billion in its accounting reports was valued at 22 m by investors a high percentage of intangible value therefore can be indicative of a firm either in liquidation, with a strong potential for bankruptcy, or providing a potential warning sign of immediate short opportunities. The Worldcom Group (WCOEQ) became a micro cap firm with market value of 59.26 m and a...

Lower Taxes on ETFs

The washing of capital gains does not always work perfectly. ETFs may be forced to make an occasional capital gains distribution because they must still sell stocks for cash that are taken private or bought by another company for cash. In addition, the exception to the rule on tax benefits is Vanguard ETFs. Vanguard funds are traditionally tax efficient. However, Vanguard ETFs are a share class oftheir open-end funds rather than a stand-alone investment vehicle. As such, all share classes of Vanguard funds are treated equally in regard to taxes. Open-end share class investors have the same level of taxable distributions as ETF share investors. Since open-end shares represent over 90 percent of the assets in a fund with an ETF share class, there is a chance that Vanguard ETFs will ultimately not be as tax efficient as they would be if the ETFs were standalones, particularly in the style funds such as the small cap value index.

The Fama French model

There are offshoots from the APT that have sought to explain historical returns by company-specific factors rather than the general macroeconomic factors in the APT. For example, Eugene Fama and Kenneth French (1995) have isolated three factors market return (as in the CAPM model), price book value (see Chapter 32), and the gap in returns between large caps and small caps (which lends credence to the notion of a liquidity effect).


Even in years such as 1971 when the big-winning stocks Southwest Airlines, Intel, and The Limited Stores all went public, a portfolio of all the IPOs issued that year trailed the returns on a comparable small-cap stock index when measured through 2003, and the same happened in 1981 when Home Depot went public. Even in the banner year 1986, when Microsoft, Oracle, Adobe, EMC, and Sun Microsystems all went public and delivered 30 percent plus annual returns over the next 16 years, a portfolio of all the IPOs from that year just barely managed to keep up with the small-cap stock index. The performance of the mostly technology IPOs issued in the late 1990s were disastrous. The yearly IPO portfolios in 1999 and 2000 un-derperformed the small-cap stock index by 8 and 12 percent per year, respectively, if measured from the IPO price and 17 and 19 percent per year if measured from the end of the first month of trading.

First Look

Looking at Figure 12.4, we see that the small-cap (short for small-capitalization) investment did the best overall. Every dollar invested grew to a remarkable 6,402.23 over the 75 years. The large-company common stock portfolio did less well a dollar invested in it grew to 2,586.52. Given the historical record, why would anybody buy anything other than small-cap stocks If you look closely at Figure 12.4, you will probably see the answer. The T-bill portfolio and the long-term government bond portfolio grew more slowly than did the stock portfolios, but they also grew much more steadily. The small stocks ended up on top, but as you can see, they grew quite erratically at times. For example, the small stocks were the worst performers for about the first 10 years and had a smaller return than long-term government bonds for almost 15 years.

SP US Equity Indexes

The S&P 400 Mid Cap Index and S&P 600 Small Cap Index are also managed using the same fundamental selection criteria and their big brother S&P 500. Both of those indexes are also categorized as passive selection under Index Strategy Box methodology for the same reason as the S&P 500 is. Combining the S&P 500, the Mid Cap 400, and the Small Cap 600 indexes makes up the S&P SuperComposite 1500. The combined index represents about 85 percent of the total U.S. equity market capitalization. To fill in the remaining 15 percent gap in the S&P index series, the S&P Total Market Index (TMI) was created. It includes all common equities listed on the NYSE, the AMEX, the NASDAQ, and the NASDAQ Small Cap exchanges. When the S&P 500 stocks are excluded from the TMI, the result is the S&P Completion Index. That index holds about 4,500 stocks.

Morningstar Indexes

Market Index into three cap indexes by defining each as a percentage of the market cap of the investable universe. Large Cap equals the largest 70 percent of investable market cap, Mid Cap equals the next 20 percent and Small Cap is the next 7 percent of investable market cap. The final 3 percent are micro cap stocks, which are not represented in style boxes.

Data sources

Although we offer some longitudinal comparisons, our analysis is based primarily on 1997 fiscal-year data, since this was the first year covered by the new UK disclosure requirements.The UK data analysed in this paper are drawn directly from the annual reports for the 510 largest companies (ranked by market capitalisation). The pay and ownership data are matched to Datastream data on company size, industry, and performance.Together, these companies account for virtually all (98 ) of the market capitalisation of the entire UK stock market. The fiscal 1997 US compensation and company data are extracted from Standard and Poor's (S&P's) Compustat's 'ExecuComp' database, which includes proxy-statement data for 1,666 top executives in the S&P 500, the S&P Mid-Cap 400, the S&P Small-Cap 600, and other supplemental S&P indices. For each country and company, we identified the CEO (or most senior executive officer), and collected information on share ownership, current and prior option grants,...


Another service to consider is headed by John Pugsley, author of the former bestseller The Alpha Strategy. Pugsley is very bullish on natural resources. He'll help you discover commodity and small-cap stock opportunities with tremendous potential that your broker hasn't heard of. Pugsley is also chairman of the Sovereign Society listed in Appendix C' and membership is highly recommended by the author. Visit his Web site at, and the Sovereign Society website at www to learn more.

Country Indexes

State Street has had success in the global small cap market with its SPDR Russell Nomura Small Cap Japan ETF (symbol JSC). It was launched in November 2006 and has assets approaching 200 million. There were only a few small cap international ETFs at the time JSC was launched, and first-to-market ETFs always reap a good harvest if the product is decent.

Stock Analyst ETFs

The BIR research team produces the master list by blending the individual rankings of each independent research company to establish a composite score. Several ETFs are formed from the master list. The Claymore BIR Leaders 50 (symbol BST) follows the BIR Leaders 50 index, which represent the stocks with the highest rankings. The Claymore BIR Leaders Mid Cap Value (symbol BMV) and the Claymore BIR Leaders Small Cap Core (symbol BES) follow BIR subsectors that represent those areas on the master list.

Stack fund choices

Just as you can purchase shirts or sweaters in small, medium, and large sizes, you can purchase stock in small, medium, and large companies. The size of a company is defined by the total market value (capitalization) of its outstanding stock. Small companies are generally defined as those that have total market capitalization of less than 1 billion. Medium-sized companies have market values between 1 billion and 5 billion. Large-capitalization companies have market values greater than 5 billion. These dollar amounts are somewhat arbitrary. (Note The term capitalization is routinely shortened to cap, as in small-cap company or large-cap stock.) Why care what size of companies a fund holds Smaller companies typically pay smaller dividends but appreciate more. They have more volatile share prices but tend to produce greater total returns. Larger companies' stocks tend to pay greater dividends and on average are less volatile but produce slightly lower total returns...

Stable distributions

Diseconomies Scale

Figure 1 shows quantile-quantile (qq)-plots of daily returns versus the best-fit Normal distribution of nine randomly selected Micro-cap stocks for the two-year period 2000-2001. If the returns were Normally distributed, the quantile points in the qq-plots would all fall close to a straight line. Instead they all deviate significantly from a straight line (particularly in the tails), reflecting a higher probability of occurrence of extreme values than predicted by the Normal distribution, and showing several outliers. Fitting Stable distributions micro-caps example. Noting that micro-cap stock returns are consistently strongly non-normal (see sample of normal qq-plots at the beginning of this section), we fit stable distributions to a random sample of 182 micro-cap daily returns for the two-year period 2000-2001. The results of the 95 confidence interval for the estimation of the tail weight parameter alpha are displayed in the boxplot in Figure 6. ESTIMATED ALPHAS OF 182 MICRO-CAP...


Small Cap Unknown boring businesses. FIGURE 11.1 Russell 2000 Small-Cap Value ETF IWN Source Chart courtesy of FIGURE 11.1 Russell 2000 Small-Cap Value ETF IWN Source Chart courtesy of FIGURE 11.2 Russell 2000 Small-Cap Growth ETF IWM Source Chart courtesy of FIGURE 11.2 Russell 2000 Small-Cap Growth ETF IWM Source Chart courtesy of Let's look at how ETFs linked to these indexes performed graphically using just IWN Russell 2000 Small Cap Value ETF in Figure 11.1 and IWM Russell 2000 Small Cap Growth ETF in Figure 11.2.

The experiment

Hemscott is a website dedicated to providing financial information. In 2003 2004, Tom Stevenson was Hemcott's head of research and in that capacity he wrote about the systematic approach to selecting shares. He regularly reviewed systems such as Jim Slater's price earnings to growth (PEG) ratio, Michael O'Higgins high-yield approach and David Dreman's contrarian low price earnings ratio (PER) method. Using these systems of selecting shares and using Hemcott's database, he drew up four shortlists from the FTSE Small Cap index. These were the following


This question tests your fundamental understanding of a stock s value. The short answer to the question is, It depends. While at first glance it may appear that the stock with the lower price has more room for growth, price does not tell the entire picture. Suppose the 2 stock has 1 billion shares outstanding. That means it has 2 billion market cap, hardly a small cap stock. On the flip side, if the 60 stock has 20,000 shares gives it a market cap of 1,200,000, and hence it is extremely small and is probably seen as having higher growth potential. Generally, high growth potential has little to do with a stock's price, and has more to do with it's operations and revenue prospects.

BottomUp Analysis

Figure 19.3 illustrates the ratio comparing the price-to-book ratio (P B) of small cap stocks versus large cap stocks. The valuation of large company stocks became very expensive relative to small company stocks during most of the 1990s. By early 2000, the valuation of large cap was the highest it had ever been relative to small cap. Prices cannot climb to the moon, however. Large cap stocks underperformed small stocks for five years following the peak, and a comparison of P Bs actually fell below historic norms.

The cost of capital

On the other hand, PowerShares has launched some sector indexes that aren't available in conventional form. These might include Water, Alternative Energy and Microcap indexes paired with associated ETFs for example. If these types of sectors appeal to you, then these ETFs may be your only choice.

Where To Download Microcap Millionaires

The legit version of Microcap Millionaires is not distributed through other stores. An email with the special link to download the ebook will be sent to you if you ordered this version.

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