How to get big returns from a small-company portfolio
Sorting stocks based on quality and not just size delivers a consistent premium
- Investors have long been told that smaller-company stocks generally offer higher potential returns, but often find that the “small-cap premium” disappears unpredictably. How can investors hold on to strong returns in small-cap investing? By buying only high-quality companies, according to AQR Capital Management managers Clifford S. Asness and Andrea Frazzini, Chicago Booth’s Tobias J. Moskowitz, and NYU Stern’s Lasse H. Pedersen.
- The researchers define quality according to various measures of profitability—gross profits, margins, earnings, accruals, and cash flows—and the five-year growth rate in each of the profit measures. They also consider the profit returned to shareholders—with larger payouts indicating higher quality—and safety, as measured by the volatility of profits and stock returns, the amount of leverage, and the risk of bankruptcy.
- Ranking stocks according to these quality measures, the researchers created a portfolio in which they purchased the highest-quality stocks and shorted an equal dollar amount of the lowest-quality stocks.
- Had investors continued to control for quality, the “golden age” of US small-cap investing that characterized the 1960s and 70s would have continued, the researchers argue (see chart). Moreover, on their measure, small-cap returns were robust in many international markets.