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How retail investors can beat Warren Buffett

It’s not by doing what the institutions do.

This article was originally published in Moneyweb’s monthly investment magazine, The Investor – now available for download in PDF format.

Is everyone a value investor now? And if so, how is it possible to outperform the market? A value investing strategy involves selecting companies with certain metrics that indicate they offer value. The most common are a high dividend yield, low price:earnings ratio and high book value relative to the price.

The strategy received a lot of great PR when the dot.com bubble burst in 2001, and all those investors who avoided sexy IT stocks with sky high valuations were left looking like the smartest investors around. One of those was Warren Buffett, who steadfastly avoided IT stocks even when his own client called him mad for doing so. One of his quotes from the time, just as the bubble was bursting, summed up his attitude: “The fact is that a bubble market has allowed the creation of bubble companies, entities designed more with an eye to making money off investors rather than for them.”

In SA, most fund managers follow the value mantra. Market giant Allan Gray has long pursued a deep value strategy and it’s the clear focus of up-and-coming institutions like RECM. But, as Buffett would know, a craze can never last. If everyone is pursuing the same strategy, a genuine market advantage would be priced out.

But what is the alternative to value investing? At the time of the dot.com bubble, the story was all about growth. Growth investing aims to invest in companies that are going to grow faster than the rest of the market. Locally, stocks such as Aspen and Naspers are good examples. They are expensive, but investors are expecting them to grow profits fast enough to justify the current price.

One misconception is that growth investing involves buying stocks that are expensive. That is not the case. Growth investors want stocks that are cheap, relative to others. Their style, though, is to figure out what the growth prospects are. The best known global growth investor is Peter Lynch who has built Fidelity’s Magellan fund into a giant by focusing on growth. He likes to “get in at the bottom floor” – in other words, young companies with good prospects. Unlike the dot.com stars, he wants companies that are already profitable and have good balance sheets and the businesses need to be simple. A lot of that sounds like something Warren Buffett would say, except that Lynch is interested in much smaller companies than Buffett, who focuses on mature firms.

Research gives good support to strategies like Lynch’s. One way to test it is to look at how small companies perform relative to large companies. That reveals the “small cap effect”. In the US, the evidence is clear that small caps outperform – one study showed that small caps have averaged a return of 20% since the great depression, compared with 11% for large stocks. That outperformance holds even if you look at risk-weighted returns, which adjusts returns based on the market beta of stocks (relative volatility of share prices). The research shows, though, that there can be long periods when small caps don’t outperform, so it holds only in the long run.

The small cap effect holds in South Africa too. On a 20-year view (it’s much harder to get data for longer), small caps have outperformed the top 40 index by about 28% (see figure 1), so the premium averages out at about 1.5% per year, which is considerably smaller than the US. However, there were considerable periods of underperformance, particularly around the time of the dot.com bubble and then again around the 2008 financial crisis related crash.

The lesson is clear: you don’t want to be in small cap stocks during periods of crisis, but otherwise they outperform. Apart from South Africa, the small cap effect has also been shown in studies of the UK (7%), France (8.8%) and Japan (5.1%). Another study looked at 20 different markets and detected a small cap effect in 19 of them.

Small-Cap-graph-1

Figure 1: Top 40 index vs small cap index

Research on the US market by Aswath Damodaran at the Stern School of Business shows that the small cap effect is greatest among microcaps – so the smaller the company, the better. Such companies tend to be ignored by research analysts at the institutional brokers and also by large fund managers. They have additional risks to them like liquidity risk – the chance that you won’t be able to sell them when you need to – and governance risk because of the lack of scrutiny by the investment analyst community. It may be that these additional risks are the reason for the premium. Transaction costs are also higher, because the spread between bid and offer prices is always higher on small cap stocks compared with large, highly liquid stocks.

These considerations mean that small cap investing is really best left to individual investors who are going to be making smaller bets and can be patient in waiting to get good entry and exit prices. The research suggests that these are good elements to an effective small cap growth strategy:

  • A long time horizon (decades, preferably). The US research shows that portfolios held for five years or less do better in large caps than small caps. Over five years, small caps tend to win.
  • Discipline and diversification become even more important. You need a large portfolio of different stocks to spread the risks.
  • You need to do the research yourself, including assessing how trustworthy management are to report the real picture of the business to you. You need to follow the news media and even attend results presentations.

Other growth investing strategies include backing initial public offerings of stocks and large cap strategies that depend on estimating growth rates. These are all more difficult for smaller investors to pursue.

Despite all the hype around value investing, a small cap strategy could well be wise for retail investors.

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