The Size Effect Is DEAD

The sad reality is that the size premium is at best – inconsistent. At worst – dead.

Academic research shows a historical annual premium of 3.5% by investing in small stocks since 1927. My personal research shows that since 2011, investing in microcaps has resulted in 9% annual under-performance when compared to the S&P 500.

Ready for the good news? There are logical quantitative techniques that can be applied to bring the size premium back to life bigger than ever. Scroll down to read about just one simple technique that has historically led to twice the annual return in smallcaps.

The Size Effect Resurrected

Since 2000, the average annual return for microcap* stocks with positive trailing 12 month free cash flow is 18.39% versus 0.89% for microcaps which are free cash flow negative.

Free cash flow is operating cash flow minus capital expenditures. Why has positive free cash flow been such a major predictor of returns? No firm is sustainable unless more money comes in than goes out. Why not use earnings? The income statement is incomplete for smaller companies. Consider just two reasons why:

  1. Earnings includes money that is owing to the firm but not yet paid. Ever have that friend which owes you money but never pays? Cash flow statements makes no such assumptions. It is simply money in and money out.
  2. Earnings will reflect amortizing capital expenditures. What if it took you $3 to make $1? A dumb business right? Once you amortize the $3 capital expenditure over 20 years, you could show huge positive earnings in the first year even though you are ultimately losing money. The cash flow statement will show this as a negative right away. A firm with positive earnings can still go bankrupt if they are not cash flow positive.
0%
Annual return with NEGATIVE free cash flow
0%
Annual return with POSITIVE free cash flow
*The investable microcap universe is restricted to stocks on major US exchanges with less than $350 million in capitalization. Illiquid stocks trading at less than $1 per share or $100,000 of average daily turnover were removed.

Quantitative Microcap Models

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