Interactive Investor

The big opportunity for the small investor

22nd April 2015 14:16

Ben Hobson from Stockopedia

Warren Buffett, the billionaire investor behind US conglomerate Berkshire Hathaway, once observed that, "a fat wallet is the enemy of superior investment results". He was referring to a problem that's inherent among large investors. Namely that that bigger your investment pot, the harder it is to find opportunities that can truly "move the needle" and generate returns you really desire.

In his early days, Buffett achieved stunning results from small-cap trades. But as the capital at his disposal grew, he was forced to search among larger and larger companies to try and sustain those returns. In one shareholder meeting he conceded that he could generate 50% returns if only he had less money to invest.

In finance academia, the so-called size-effect - the phenomenon that small stocks outperform large stocks - was identified in the early 1980s and became regarded as a major driver of long-term stock market returns.

Yet over the past 25 years there has been increasing scepticism that small stocks really do outperform. Analysts claimed that the size effect seemed to be intermittent and that the costs of trading small shares ultimately ruined the returns.

Good things come in small packages

But just as it was looking as if size really didn't matter, research has found that it is indeed a very powerful force in the market - but only if you combine it with another vital factor: quality.

Back in 2013, a team of quant researchers at US fund management firm AQR Capital, found that high quality companies typically don't get the credit they deserve in the form of significantly higher share prices. Like many analysts, AQR use quality to describe companies that are profitable, growing, low risk, with stable earnings and a record of being efficient at investing their own capital. They found that you could outperform the market by buying high quality stocks and shorting low quality stocks.

More recently, AQR applied this quality-focused strategy to small stocks and found that the size effect becomes much more obvious. It turns out that because smaller companies generally tend to be of lesser quality than larger companies, it can be difficult to see the size effect in action. In other words, small quality stocks outperform large quality stocks.

Trading the size effect

To get an idea of where to find smaller, good quality shares, Stockopedia screened the market for Interactive Investor using something called the QualityRank. This scores and ranks every company in the market using financial measures that look at each company's profitability, financial strength and risk - from zero (low quality) to 100 (high quality).

NameMkt Cap £mQuality RankSector
32Red50.3100Consumer cyclicals
Brainjuicer50.899Consumer cyclicals
City of London Investment92.399Financials
XP Power282.699Financials
Liontrust Asset Management122.898Financials
Character7898Consumer cyclicals
Somero Enterprises Inc77.398Industries
Andrews Sykes135.297Industries
Utilitywise155.497Industries
London Security263;697Technology

The list includes 32Red, the online casino and bingo operator, which has seen its shares rise by 80% since the start of the year (when its QualityRank was 96). It is followed by BrainJuicer, the marketing and brand consultancy, and asset management company, City of London Investment Group, which happens to be the largest holding in Mark Slater's MFM Slater Income Fund. Elsewhere, there is XP Power, which works in power supply systems, and Character Group, the children's toy distributor, which has seen its shares rise by 39% this year.

Not all the shares here have done well in recent months. Companies like air conditioning business Andrew Sykes and energy intermediary Utilitywise have both seen year-long negative price momentum. So taking a portfolio approach to finding quality stocks is important, and it is likely to be safer to use combinations of factors, including the likes of value and momentum.

Since Stockopedia began tracking StockRanks in 2013, a basket of annually rebalanced small-cap stocks in the top 20% of the market for Quality Rank has returned 31.9% against 15.2% from the FTSE All-Share. The bottom 20% - lowest quality stocks - has lost 18.6%.

The latest research into the size effect supports the view that small stocks can outperform large stocks. However, smaller companies can be hit by unexpected problems, so a focus on quality is vital. The good news is that when it comes to investing in them, private investors do have an advantage.

As Joel Greenblatt neatly sums it up in his book, "The Big Secret for the Small Investor": "Some of the greatest battles in history have been won by armies that are severely outmanned and outgunned… Investing in smaller-capitalisation stocks is a game involving thousands of companies worldwide, and most institutions are just too big to play. Luckily you're not."

About Stockopedia

Interactive Investor's Stock Screening series is written by Ed Page Croft of Stockopedia.com, the rules-based stockmarket investing website. You can click here to read Richard Beddard's review of Stockopedia.com and learn more about the site.

● Interactive Investor readers can enjoy a two week free trial and £50 discount to Stockopedia using the coupon code iii014 - click here.

● To learn more about Ben Graham and his deep value investing strategies, you can download the free Stockopedia book, How to Make Money in Value Stocks.

It's worth remembering that these and other investment articles on Interactive Investor are simply for generating ideas and if you are thinking of investing they should only ever be a starting point for your own in-depth research before making a decision.

*No fee for publication is involved between Interactive Investor and Stockopedia for this column.

About the author

Ben Hobson is Strategies Editor at Stockopedia.com. His background is in business analysis and journalism.

Ben writes regularly on investment strategy performance and screening ideas for  Stockopedia. He is the author of several ebooks including "How to Make Money in Value Stocks"

This article is for information and discussion purposes only and does not form a recommendation to invest or otherwise. The value of an investment may fall. The investments referred to in this article may not be suitable for all investors, and if in doubt, an investor should seek advice from a qualified investment adviser.