Category Archives: amex

The Small-Cap "Alpha" Myth

There is a common misconception about “alpha” in the small-cap market within the United States. Many professionals believe that once we step out of the mega-cap world of companies like Google, Wal-Mart, Coca-Cola and Apple where there is an army of analysts digging into the vast amounts of data and pricing stocks accordingly, that there is opportunity in its smaller counterparts given the perceived market inefficiency. The story goes that there are fewer analysts covering these particular companies and, therefore, there is an opportunity to produce superior risk-adjusted returns. Whenever we want to research a particular topic in investing, it is always best to start looking into peer-reviewed academic research. In fact, we published an article all the way back in 2001 that covered this particular topic. Our analysis was based on a research paper entitled “The Small Cap Myth” produced by Richard M. Ennis and Michael D. Sebastian of Ennis Knupp Associates, one of the largest pension consulting firms in the country. Based on a sample of 128 small-cap managers, they concluded that once we adjusted for (1) management fees, (2) improper benchmarking, and (3) survivorship bias within the sample, the average “alpha” fell to virtually zero. Aon Hewitt, another large consulting firm, recently published its own research on the small-cap “alpha” myth in January of this year entitled “The Small-Cap Alpha Myth Revisited.” Based on the eVestment Database of small-cap equity managers, the researchers found that the median performance of these managers was worse for the 10-year period ending June 30, 2015 than the original analysis in 2001. The median performance across all styles in the small-cap market was less than 1% (originally around 4%). Once the researchers adjusted for survivorship bias, back-fill bias, liquidity and transaction costs, which the researchers estimated to be almost 200 basis points, the median results were actually negative. Click to enlarge Similarly, we can compare the average performance of all 479 actively managed small cap funds (as classified by Morningstar) against commercial benchmarks like the Russell 2000 Index and S&P Small Cap 600 Index. If we then add small-cap index funds from Dimensional, Vanguard and iShares, we have a nice comparison chart over the 15-year period ending 12/31/2015. As you can see below, the average actively managed small-cap fund underperformed the Russell 2000 Index by 0.24% per year and the DFA U.S. Small Cap Fund by 2.0% per year, net of fees. These results not only highlight the ” arithmetic of active management ” that Nobel Laureate Bill Sharpe reminds investors of, but also the potential benefits of utilizing a strategy, such as the one offered by DFA, that can better capture the small size premium by designing their own DFA small-cap index that has a smaller weighted average market capitalization than other indexes. Click to enlarge How can different index funds produce significantly different performances if they are all targeting the same asset class? In short, differences in performance come from differences in indexes. For example, the Russell 2000 Index focuses on the bottom 2000 companies in terms of market capitalization in the Russell 3000 Index. DFA, on the other hand, defines its Small-Cap Index as a market-capitalization-weighted index of securities of the smallest US companies whose market capitalization falls in the lowest 8% of the total market capitalization of the eligible market ( see details here ). The eligible market is composed of securities of US companies traded on the NYSE, NYSE MKT (formerly AMEX), and Nasdaq Global Market. Exclusions include non-US companies, REITs, UITs and Investment Companies and companies with the lowest profitability and highest relative price within the small cap universe. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. You can find an even more detailed explanation of the historical composition of their indexes in the footnotes below. It is an important reminder that DFA is not new to the indexing industry. In fact, it is one of the pioneers of understanding and implementing index-based strategies. There is no “right” answer, but DFA’s approach seems to better capture the small-cap premium. It is a delicate balance between maintaining strong diversification, pursuing the small cap premium, and keeping trading costs as low as possible. The chart below displays the historical annualized return and standard deviation for a few DFA and Russell Indexes over the last 37 years. You can see that DFA generates a higher return than Russell by better capturing risk premiums in the stock market. Click to enlarge In its own words, Aon Hewitt summed up belief in the small-cap “alpha” with the following: “The widely held assumption that inefficiencies within the U.S. small- cap equity market should lead to greater opportunity for active management than the large-cap equity market appears to be just as mythical in 2015 as it was in 2001. The growth in actively managed assets within the small-cap space over the past 14 years may be significantly contributing to the lack of inefficiency that many market participants erroneously assume.” We couldn’t agree more. Click to enlarge IFA Painting: The Size Premium Disclosure: I am/we are long DFSTX. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.

The V20 Portfolio: Week #31

The V20 portfolio is an actively managed portfolio that seeks to achieve an annualized return of 20% over the long term. If you are a long-term investor, then this portfolio may be for you. You can read more about how the portfolio works and the associated risks here . Always do your own research before making an investment. Read the last update here . Note: Current allocation and planned transactions are only available to premium subscribers . Over the past week, the V20 Portfolio declined by 5% while the SPDR S&P 500 ETF (NYSEARCA: SPY ) dipped by 0.3%. Portfolio Update It would appear that the saga of Dex Media (NASDAQ: DXM ) (OTCMKT: OTCPK:DXMM ) will soon come to an end. It was my hope that the management could come to an amicable agreement with lenders given the company’s massive cash flow. Unfortunately, we cannot control the outcome of the negotiation and according to the most recent press release from company, an agreement has been reached with lenders, the outcome being that equity holders will be completely wiped out. Evidently the thesis has failed to play out, but the risk of total loss was something that we accepted all along. For myself, what’s troubling is that the management voluntarily defaulted for reasons that are still unclear to me. When the company defaulted in 2015 by withholding an interest payment, the company still had plenty of cash and was on track to generate more. What really boggles my mind is that the management was somehow able to gain support from both senior and junior debt holders. To put things into perspective, the management withheld $8.9 million of cash interest back in September from junior debt holders and pushed the company into default. Now that negotiations are finished, junior debt holders will get wiped out save a $5 million payment and warrants on the new equity. Clearly it was absolutely not in their interest to consent, yet the improbable has occurred. In any case, Dex Media will likely be a write-off unless a miracle happens in court. While this investment has been a failure, the impact on the overall results of the V20 Portfolio has been minimal, which is one of the reasons why the investment was attractive in the first place, as the downside was limited when the position was viewed in the context of the whole portfolio. The V20 Portfolio began the year with just 0.5% of assets being allocated to Dex Media. On to better news. Our sole insurance company reported Q1 earnings and as expected, the company continued to demonstrate strong growth and profitability. The market reacted favorable as well, boosting the stock by roughly 10% since earnings as of close on Friday. Turning our attention to Conn’s (NASDAQ: CONN ), the company recently reported April sales data, meaning that now we have all the sales numbers for Q1. Overall, sales grew 8% year over year from $296 million to $319 million. While growth will continue to add value in the long-run, the company must show some improvement in the credit segment in the near term to get rid of the negative sentiment surrounding the stock. Spirit Airlines’ (NASDAQ: SAVE ) performance mirrored the sustained pessimism in the airline industry, shedding 6.5%. In comparison, AMEX Airline Index declined 3.9%. This has occurred despite Spirit Airline’s leading profitability and growth potential. Due to our earlier trim, the position has declined to less than 10% of the overall portfolio, hence more capital will be allocated to Spirit Airlines. Click to enlarge Disclosure: I am/we are long CONN, SAVE, DXMM. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article. Editor’s Note: This article covers one or more stocks trading at less than $1 per share and/or with less than a $100 million market cap. Please be aware of the risks associated with these stocks.

The V20 Portfolio: Week #30

The V20 portfolio is an actively managed portfolio that seeks to achieve an annualized return of 20% over the long term. If you are a long-term investor, then this portfolio may be for you. You can read more about how the portfolio works and the associated risks here . Always do your own research before making an investment. Read the last update here . Note: Current allocation and planned transactions are only available to premium subscribers . Bonus: Recently I was interviewed by Investor In The Family , a podcast that touches on all facets of the investment world. I talked about some of my investment philosophies and why the V20 Portfolio was able to outperform. I will dedicate another piece to elaborate on certain points, but you can listen to the podcast today right here . Over the past week, the V20 Portfolio declined by 3.7% while the SPDR S&P 500 ETF (NYSEARCA: SPY ) slipped by 1.3%. Portfolio Update Despite beating earnings on Tuesday, Spirit Airlines’ (NASDAQ: SAVE ) stock shed 11.6% over the past week. The decline reflected the general pessimism towards the airline industry, as demonstrated by AMEX Airline Index’s 2.9% drop. I believe that the biggest contributor to the loss was rising oil prices. While fuel expense was still down quarter on quarter, the rallying commodity market will inevitably increase the price of fuel should the current uptrend persist. This is a macro factor that every single airline is exposed to, but I believe that Spirit Airlines will be among the least affected. Its strong operating margin (~20%) means that increasing fuel prices will be less damaging to the firm’s bottom line. To illustrate, a 500 bps increase in fuel expense as a percentage of revenue will wipe out 25% of operating profits for Spirit Airlines, whereas the same increase will erase 50% of operating profits of a company running on a 10% operating margin (e.g. Virgin America). Despite the fact that oil was climbing to new highs, Conn’s (NASDAQ: CONN ) was not able to benefit. Given disappointing retail sales in March (-0.3% actual vs +0.1% expectation), sentiment may worsen next week. While we should not be overly concerned with these month-to-month reports, it is still worthwhile to understand how macro factors can affect investors’ perception in the short term. One company that did directly benefit (at least from a market perspective) from climbing oil prices was our helicopter transportation company. While shares have appreciated, it is very possible that the company’s oil and gas revenue will continue to deteriorate in 2016. In the long-run, rising oil prices will still benefit the company by increasing demand for air transportation. However, this does not preclude the company from suffering short-term setbacks. The market has been efficient enough to recognize that distinction, at least over the past couple of weeks. The title of being the second biggest position, which belonged to Spirit Airlines, was usurped by an insurance company when we carried out our major transformation at the beginning of April. Thus far, shares have traded sideways. No matter how well the company performs in Q1 and Q2, Investor sentiment may not reverse until hurricane season passes given the company’s exposure in Florida. In that sense, next week’s earnings release may not be as important as you think. Performance Since Inception Click to enlarge Disclosure: I am/we are long CONN, SAVE. I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it. I have no business relationship with any company whose stock is mentioned in this article.