The Real Risk and Rewards

of Small-Cap Equities

BY STEVE SCHUDIN

SUMMER, 2016

Generally Accepted Assumptions about Small-Cap Stocks:

1: Small-cap stocks don’t pay dividends therefore any return will be from capital gains alone.

2: A group of equities is inherently more risky simply by being smaller in terms of capitalization and that, conversely, that must mean that larger equities are less risky.

Assumption 1: Most Small-Caps are Not Dividend Payers

This is only true of the smallest of publicly-traded companies (less than $100 million market cap.)

A lower percentage of small-caps pay dividends than large caps, but only because there are far more of them. More small caps pay dividends than large caps numerically.

Dividend yields average higher for small-caps than for large caps.

The Total Market by Capitalization

Only 17% of U.S. public equities have a market cap above $5 billion as of July 1st, 2016.40% of the market is below $100 million market cap.

Dividend-Payers as a % of the Market

Dividend-payers are above 50% all the way down to $1-.5 billion market-cap.Dividend payers by capitalization only fall below the total market average below $.25 billion.

Dividend Payers Across the Market-Caps

With the exception of the $5-1 billion portion of the market, the distribution of dividend-paying equities across all market-caps is much more even than is usually thought.

Dividend Yield by Market-Cap

The average 5-year dividend yield percentage actually increases below $5 billion capitalization. An equity cannot be purchased on this basis alone, but it is a factor to consider that goes against the popular perception of small-caps.

Assumption 2: Small-Caps are More Risky

Small-caps are undoubtedly more volatile than large caps.

The share-price fluctuations that one commonly sees with small-caps has little to do with changes in the underlying business as each small-cap public company is followed by few, if any, analysts.

It is easier to move the share price of small-caps due to far fewer shares outstanding, even when allowing for lower trading volume.

Trading Volume Relative to Outstanding Shares 1: Trading Volume by Market Cap

Small-caps are ‘thinly traded’, though more volatile. Trading volume drops by market cap, then increases at $100 million.

Trading Volume Relative to Outstanding Shares 2: Average Shares by Market Cap

As market capitalization goes down, average shares outstanding take steep drops except at $100M and below.

Trading Volume Relative to Outstanding Shares 3: A Variation on Share Turnover

Even with much higher trading volumes among the large caps, each trade has a higher impact on small-caps relative to the average number of outstanding shares, thus creating volatility.

Median Share Price, Trading Volume and Volatility or ‘The Penny Stock Pox’

Below $100 million market-cap is where most of the volatility that small caps are known for can be found; as more companies and average shares outstanding combines with a median share price below $.50.

Skimming the Top 1The stock screener on Zacks.com had data on 1,933 stocks from the Russell 2000. Screening for dividend payers yielded 808 stocks, or 42% of the total.

Of those 808 stocks, screening for current assets/total liabilities (CA/TL) above 2 yielded 130 companies or 6.5% of the total.

CA/TL = my favorite balance sheet ratio.All liabilities have to be paid from operations, not just current.Long-term assets can only be used to pay liabilities if they are sold off, thus decreasing capacity for future operations.

Skimming the Top 2From 2000-2015, the major U.S. indices returned:S & P 500: 5.67%Russell 2000: 7.18%

Using the index benchmarks; small-caps have beaten large-caps by 26.5% since 2000.

The criteria on the previous slide + a current ratio above 4 and a cash/debt ratio above 0.2 yielded 44 stocks that would have returned an average of 21.4% from 2000-2015.

Knowing Up From DownA common criticism of Beta and the Sharpe Ratio: they do not distinguish between upward and downward volatility, so that higher gains over time can result in a higher Beta or a lower Sharpe ratio.

The Sortino ratio remedies this issue by penalizing an equity only on its downward volatility.

The Sharpe ratio using the 10-Year Treasury bond for RFRR: Portfolio – 0.55, Russell 2000 – 0.17, S & P 500 – 0.01

The Sortino Ratio: The portfolio vs. the Russell 2000 – 3.69

Conclusions1) Small-cap equities do ‘hold their own’ against large-caps as income-producers in a portfolio through the paying of dividends.

2) Small-cap equities are not as risky as typically thought provided that due diligence is always kept high.

3) Many of the prejudices that the average investor has towards small-caps only become true when one looks below $100 million. Above $100 million, they are not as risky.

4) Directional volatility is an important consideration rather than general volatility.