Cheap stocks with higher return on equity and lower leverage have outperformed other small stocks, based on comparing the portfolios of deep value small-cap funds (such as Aegis Value, down about 25%) with those focusing on “high quality” (such as Perkins Small Cap Value, up 3.2% and outperforming 92% of similar funds).  Tom Reynolds, co-manager of the Perkins fund, explains that he has focused on quality and emphasizes industrial companies and banks rather than energy stocks.

A January 2015 report by AQR Capital Management found that from 1957 to 2012 quality small-cap stocks outperformed the market by 5.9% annually.  Ronen Isreal, co-author of the study, summarizes: “Controlling for quality really bumps up the return.” The focus on high quality small-cap stocks builds on the well-known work of Nobel Laureate Eugene Fama and Kenneth French, who identified small-caps as the most likely to generate excess returns.  Recent data from small cap funds like Aegis Value, however, suggest the need to identify small-caps prepared to weather downturns.  Focusing on high quality small-caps may be the answer according to this piece in Barron’s.