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The Size Effect (or Myth?) and other Anomalies

     Many studies have shown that small firms (capitalization or assets) tend to outperform. The small stock affect was first documented by Rolf Banz.1 He divided the stocks on the NYSE into quintiles based on market capitalization. The returns from 1926 to 1980 for the smallest quintile outperformed the other quintiles and other indexes. Others have argued that it’s not size that matters, its attention and number of analysts that follow the stock.

     This anomaly is subject to intense debate over whether an opportunity to generate excess returns actually exists. Many studies show that small capitalization stocks outperform large stocks in the United States, as well as in foreign markets. However, others argue that it’s not reasonable to assume that investors can realize those returns. Jeremy Siegel argued in Stocks for the Long Run that the period from the end of 1974 through the end of 1983 accounted for the whole outperformance of small caps. Jack Bogle was quoted in the Wall Street Journal (2/10/1997) noting that since December in 1978 small caps and large caps had earned exactly the same returns.

     James O'Shaughnessy had also argued in the first edition of What Works on Wall Street that the returns in small stocks were attributable almost entirely to micro-cap stocks with market capitalizations under $25 million. Small stocks typically have large spreads and commissions and cannot be bought by institutional managers without significantly moving the share price. Therefore, he argued that even so called "small company" funds have difficulty taking advantage of small capitalization stocks.

     Mark Hulbert argued in "The small-cap myth" in Forbes (March 10, 1997) that after accounting for commissions when buying small stocks, there was no advantage. In the same issue of Forbes, David Dreman (in "When statistics lie") pointed out that the Banz study included only stocks from the NYSE which are larger than small stocks from other exchanges. Dreman also stated that much of the data is based on stocks that traded thinly or not at all, the point being that you couldn't really buy them in large quantities, if at all at their quoted price. On the impact of trading costs and liquidity on the analysis of small-cap performance, Marc Reinganum commented that "Several academic papers have been written on this topic, and depending upon whose you read, some have negated the fact that a small-cap effect exists. Others support the notion that, even taking the transaction costs into account, small caps carry some premium. The answer depends on how the studies are structured."2

     Larry Swedroe suggested in a more recent article that the size effect won’t disappear and using data from July 1926 through November 2017 found annual returns from small cap value stocks of 14.8%, versus 9.8% for large cap growth (12.1% large value and 8.7% small growth).3

     When people in the investment business discuss stocks, they often refer to indexes and historical data based on those indexes. Historically the most recognized index is the Dow Jones Industrial Average (DJIA), which represents 30 of the largest U.S. firms. In recent decades, the broader S&P 500 became a commonly referenced benchmark and the first index mutual fund was an S&P fund (VFINX). While it is much broader than the DJIA, the S&P 500 is still not a complete U.S. market index. The Russell 3000 takes another step toward reflecting the complete market, but still leaves out a significant number of smaller stocks. Complete U.S. market indexes and index funds have since been developed and arguably a representative broad market index should be the primary index for benchmarking the U.S. Stock Market.

     The Wilshire 5000 represents the U.S. total equity market, and actually pre-dated the Russell 3000. It includes all U.S. equities with readily available prices (bulletin-board and thinly traded issues are excluded because in general they do not have readily available prices). The Wilshire 5000 was created in the mid 70's at Wilshire Associates (and back dated to 1970). It was originally called the O'Brien 5000 (named after John O'Brien, who sold his interest to Dennis Tito, according to Justin Fox in The Myth of the Rational Market). Dennis Tito originated the idea, along with Larry Cuneo (who wrote the code for the index calculations - initially done weekly and monthly) and Wayne Wagner (who promoted it and named it with Tito).

     The actual number of stocks in the index fluctuates based on the number of stocks listed on the exchanges. The index originally started out with roughly 4,950 stocks, with the number going much higher during the internet boom, but had less than 3,600 in 2018.4 The first actual Wilshire 5000 fund was created in the mid 1980's by Wilshire Associates for the Minnesota State Board of Investments. That fund was $1,300,000,000 - believed to be the largest first account ever as of that time. Mark Edwards worked at the Minnesota Board at the time and Wagner, Cuneo, and Edwards later combined at Plexus Group (I joined the firm in 1998).

     Smaller capitalization stocks tend to have wider spreads, trade less frequently (so last trade prices may not be achievable), and are much more difficult to trade in larger size without pushing prices. The S&P 500 is subject to rebalances whenever stocks move between the 500 and 4500 (other U.S. stocks not in the 500). As a result, the Wilshire 5000 tends to have lower turnover (and expectedly lower transactions costs) than the S&P 500. Therefore the Wilshire 5000 tends to have greater tax efficiency than the S&P 500, which is particularly relevant to taxable investors.

     Jack Bogle included another discussion of the Wilshire 5000 and the S&P 500 in The Little Book of Common Sense Investing. Bogle noted that the Wilshire 5000 "is the best measure of the aggregate value of stocks, and therefore a superb measure of the returns earned in U.S. stocks by all investors as a group." Bogle compared the S&P 500 and total market returns back to 1926 using data from the Center for Research in Security Prices (CRSP). He concluded that for the full period the S&P500 return was 10.4% versus 10.2% for the Total Stock Market Index. Starting from 1930, both returned 9.9%.

     The decision to invest in specific stocks, or sectors, or styles in an attempt to beat the broad benchmark presents a tradeoff between costs (which investors tend to underestimate) and probability of success (which investors tend to overestimate).

     There are other broad market indexes, in fact, major broad market index funds tend to each use different indexes. There are some potentially significant differences (like country of incorporation or minimum stock prices used for determining which stocks are included), but for the most part the indexes and funds have very high correlations. Funds based on the different broad indexes may also use slightly different techniques to invest in a representative sample of the index.

     Vanguard's total market portfolio ETF (VTI) is a good default and has an expense ratio of 0.04%. Vanguard switched the benchmark on their total market funds from the Wilshire 5000 to the Morgan Stanley Capital International (MSCI®) U.S. Broad Market Index, which supposedly represents 99.5% or more of the total market capitalization of all the U.S. common stocks. Fidelity started offering a free (zero expense) total U.S. stock market index fund, while Charles Schwab’s ETF SCHB costs 0.03% and seeks to track the Dow Jones U.S. Broad Stock Market Index. State Street also offers its SPDR Portfolio Total Stock Market ETF SPTM with a 0.03% expense ratio.

Announcement Based Effects and Post-Earnings Announcement Drift (PEAD)

Price changes historically have tended to persist after initial announcements. In other words, stocks with positive news surprises tended to drift upward, while those with negative surprises tended to drift downward. Some refer to the likelihood of negative earnings surprises to be followed by several more earnings surprises as the "cockroach" theory because when you find one, there are likely to be more in hiding. Robert Haugen in his book The New Finance: The Case Against Efficient Markets argued that the evidence implied investors initially underestimate firms showing strong performance and then overreact. Haugen concluded that "The market overreacts--with a lag" and that "we apparently have a market that is slow to overreact."

“There is evidence, and try as they might, the accountants and financial people can't make it go away, that when you get an earnings surprise, somehow or other the market doesn't seem to absorb it all right away.”
William Sharpe, in Investment Gurus by Peter Tanous

     In "Big News on Your Stock? Hold On to Your Hat" in the April 27, 1998 issue of the Wall Street Journal, Greg Ip cited a study by Robert Butman that analyzed the reactions of thousands of stocks to negative and positive earnings surprises from 1995 to 1998 and compared them with an earlier study from 1983 to 1989. The price reactions that used to take three to four weeks in the 1980's accelerated to two days in the more recent period. Many industry experts now believe the reactions are even faster, due to several factors including increased knowledge of the anomaly and the growth of high frequency trading.

     The authors of a 2009 study summarized that the post-earnings-announcement drift occurs mainly in the highly illiquid stocks, which have high trading costs and market impact costs, thus supporting for the argument that transactions costs could be the source of the drift.5

IPO's, Seasoned Equity Offerings, and Stock Buybacks

Numerous studies have concluded that Initial Public Offerings (IPOs) in aggregate underperform the market and there is also evidence that secondary offerings also underperform. Several studies have also documented arguably related market inefficiencies. Bala Dharan and David Ikenberry found that firms listing their stock on the NYSE and AMEX for the first time subsequently underperformed.6 Tim Loughran and Anand Vijh found that acquiring firms that complete stock mergers underperformed, while firms that complete cash tender offers outperformed.7 The study implied that acquirers who use their stock to effect transactions may believe the stock is overvalued.

     Stock repurchases, on the other hand, can be viewed as the opposite of stock issues, and some studies have shown that firms announcing stock repurchases outperform in the following years. This evidence seems to confirm the theory that managers tend to have inside information regarding the value of their company's stock and their decisions whether to issue or buy back their stock may signal over or undervaluation. The implication of these studies seems to be that investors may do better buying stocks of firms that are repurchasing their own stock rather than from firms that are selling or issuing more of their own stock.8

Insider Transactions

There have been many studies that have documented a relationship between transactions by executives and directors in their firm's stock and the stock's performance. Insider buying by more than one insider is considered by many to be a signal that the insiders believe the stock is significantly undervalued and their belief that the stock will outperform accordingly in the future. However, many researchers question whether the gains are significant and whether they will occur in the future. Mark Hulbert reported in “Insider Trading” in Forbes (November 3, 1997) that none of the newsletters he follows that focus on insider behavior had done well.

1. Rolf W. Banz, The Relationship Between Market Value and Return of Common Stocks, Journal of Financial Economics, November 1981
2. Marc R. Reinganum, "The Size Effect: Evidence and Potential Explanations," Investing in Small-Cap and Microcap Securities, Association for Investment Management and Research, 1997
3. Larry Swedroe, Why the Size Premium Won’t Disappear, March 5, 2018
5. Chordia, Tarun and Goyal, Amit and Sadka, Gil and Sadka, Ronnie and Shivakumar, Lakshmanan, Liquidity and the Post-Earnings-Announcement Drift, Financial Analysts Journal, July/August 2009
6. Bala Dharan and David Ikenberry, The Long-Run Negative Drift of Post-Listing Stock Returns Journal of Finance, December 1995
7. Tim Loughran and Anand Vijh, "Do Long-Term Shareholders Benefit From Corporate Acquisitions?" The Journal of Finance, December 1997
8. David Ikenberry, Josef Lakonishok, and Theo Vermaelen, Market Underreaction to Open Market Share Repurchases, Journal of Financial Economics, October 1995

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Table of Contents and Launch Site

Last update 12/18/2019. Copyright © 2019 Gary Karz. All rights reserved.
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