By Justin Carbonneau (@jjcarbonneau) —

Verdad, a value oriented and global asset manager, recently published a piece highlighting the valuation gap that exists between small caps and large cap stocks, as represented by the S&P 500. The piece, “Small caps are trading at the steepest discount to large caps in decades”, may have important implications for investors and allocators over the next decade.

In summary:

• Small caps trade at one of the widest valuation gaps vs. large caps in the last five decades.
• Future returns in small caps tend to be strong after periods when the small relative to large discount is wide.
• Over the very long-term, small-cap value stocks have historically demonstrated a long-term premium over the broader market and other styles and size cohorts of stocks.

As the paper points out, small caps have a higher failure rate, are more sensitive to economic cycles and have lower liquidity and so if you believe investors should get compensated for these extra risks then a premium should exist for investors bearing these risks. But in the last 10 to 15 years, it’s been large over small and growth over value – the opposite of that has worked over longer periods of time.

It’s important to think about whether this is structural or cyclical, and the analysts at Verdad have spent considerable time researching this question, so I won’t rehash all of that here, but one could certainly point to things like fewer recessions (small cap value tends to do extremely well coming out of recessions), a historically low and falling interest rate environment, more market efficiency and the increase in intangible assets as just a few of the contributing factors that may have flipped the small cap premium on its head over the past 15 years or so. Still, long-term history shows when the discounts between small vs. large are as wide as they are it has resulted in above average small cap returns and for those investors looking for the potential to capture those returns, looking at strategies now that select small cap value stocks may be worth considering.

Five Systematic Value Models

Validea captures investment models published in books or academic papers and builds stock selection models that rank stocks through each fundamental strategy. We run value, growth, momentum and low volatility models. Many of the models we run sit squarely in the traditional value style bucket in that they look to buy stocks with below average multiples that have some quality characteristics and may benefit from upward mean reversion over time (trying to take advantage of investors behavior bias in overestimating how bad things may be). Below you will find short video synopsizes of each, highlight the strategy at a high level and then digging into the specific methodology in the second half of each video.

Ben Graham’s Value Model

A deep value methodology that looks for stocks that have low P/B and P/E ratios, along with low debt and solid long-term earnings growth. Based on The Intelligent Investor.

Joseph Piotroski’s F-Score

This value-quant strategy screens for high book-to-market stocks, and then separates out financially sound firms by looking at a host of improving financial criteria. Based on Piotroski’s research paper on value stocks.

Joel Greenblatt’s Magic Formula

A value model looks for companies with high return on capital (à la Warren Buffett) and high earnings yields (à la Ben Graham). Based on The Little Books that Beats the Market.

James O’Shaughnessy Value Composite

This value strategy looks for inexpensive stocks using a composite of value factors. Based on O’Shaughnessy’s book, What Works on Wall Street.

Private Equity Replication in Public Stocks

Leveraged small-cap value model seeks firms that have the characteristics of successful private equity investments. Based on the published research paper from Verdad’s partners.

Don’t Forget About ETFs

Investors aren’t limited to active stock models. There are a number of exchange traded funds in the small cap value space that may be worth exploring. Here are the top five ranked small cap value ETFs ranked using our value ranking, which is composite of multiple value metrics from our ETF Factor Screener. These aren’t recommendations, but rather just ideas for investors to investigate further. The great things about ETFs is that their holdings are reported daily, so you can look under the hood to find the ETF that has the stocks with the most value exposure.

Ticker	Name	AUM	Exp. Ratio	# of Holdings	Active Share vs. S&P 500.	Value Rank (100 best)
XSVM	Invesco S&P SmallCap Value with Momentum ETF	$683,831,600	0.39%	121	100%	99
DEEP	Roundhill Deep Value ETF	$45,438,000	0.80%	99	100%	98
DWMC	AdvisorShares Dorsey Wright Micro-Cap ETF	$7,792,138	1.27%	168	100%	98
FDM	First Trust DJ Select MicroCap ETF	$154,865,800	0.60%	166	100%	98
RZV	Invesco – Guggenheim (Rydex) S&P SmallCap 600 Pure Value ETF	$297,560,600	0.35%	169	100%	98

Allocating part of your portfolio to small cap value stocks may not be appropriate for all investors. Small caps tend to be riskier and can see long periods of trailing a broad market index like the S&P 500. However, history has shown there have been times when the valuation gap between small (particularly small cap value) and large caps is wide and that has been a good indicator of strong returns out of small caps and value going forward. Time will tell if history repeats itself, but the risk/reward at this moment could be favorable for this size and style approach to investing.

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Justin J. Carbonneau is VP at Validea & Partner at Validea Capital Management.
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