Size Anomaly

The equity market anomaly website hema.zacks.com provides a comprehensive explanation of numerous stock market anomalies and details on how and why they are profitable. In this article we will focus on the effects of the size anomaly.

There's a long standing debate about whether Small Capitalization stocks outperform Large Cap stocks, which is the essence of the size anomaly. Does Small really outperform Large over the long run? By how much? Is Small or Large Cap currently in vogue?

First, let's define Small and Large Cap. Since there's no official definition about cutoff values, let's take a simple approach and label Small Cap as those stocks with a current market cap of $100 million to $1 billion and Large Cap as those stocks over $10 billion. Anything between $1 billion and $10 billion would be considered Mid Cap and those below $100 million are Micro Cap.

These definitions are in current US dollar values and, in order to perform historical backtests, need to be adjusted for inflation and market changes. So to account for these adjustments, we will convert the hard-dollar definitions to percentiles. The market cap dollar values equate to the top 10% of companies for Large Cap and those that lie in the 30-55% range for Small Cap.

Next let's use the Research Wizard to run some tests to view the performance of both Small and Large Cap stocks. The test period will start on January 1, 2000 and end on July 15, 2011. The results over those 11+ years indicate a tendency for Small stocks to outperform Large by an annualized average of 12.1%. Small Cap had an annualized return of 16.3%, versus 4.2% for Large Cap. These results show that the Small Cap anomaly does exist over the long term.

However, the market frequently changes its preferred style. The Large trend lasts on average 6.9 weeks and the Small streak lasts slightly longer at about 8.1 weeks. Even though the duration of each size is quite similar, the power of the stay is dramatically different. When Small comes into favor, it generates an average of 7.8% during those 8.1 weeks. Conversely, Large returns an average of 4.5% over 6.9 weeks. So even though the wind blows in each direction about the same length of time, the Small wind is much stronger than the Large wind.

So which direction is the wind blowing now? For most of 2011, Large Cap stocks have been outperforming. That's not surprising given the concerns about the economy and the fact that there is usually a flight to safety (Large Cap stocks are considered less risky than Small Cap) during times of uncertainty. When the dark economic clouds start to disperse, however, Small Cap stocks should come back with a bang.

• Start with Small Caps, which are defined as market caps above $100 million and below $1 billion.
  
• Place a liquidity requirement of average daily volume greater than or equal to 50,000 shares (if there's not enough liquidity, it'll be hard for you to trade it).
  
• Add another filter by selecting those stocks with a Zacks Rank = 1. (Let's also pick the stocks that are highly rated.)

Here are 5 great Small Cap stocks (07/27/11):

Mitcham Industries Inc. (MIND - Snapshot Report)

Mitcham Industries sells, leases and services seismic equipment to oil and gas companies around the world. That's a good business to be in when fossil fuels are becoming increasingly scarce. Last week, Mitcham reported record sales and net income. Earnings estimates have been increasing, analyst recommendations have been improving and the stock price has been red hot. The company was also added to the Russell 3000 last month. Valuation ratios and operating margins also look good. Inventory is flowing and cash flow is strong. This all adds up to a pretty sound Buy.

Newport Corp. (NEWP - Snapshot Report)

Newport Corporation develops, manufactures and sells precision technology products for scientific research, microelectronics, aerospace, defense, health sciences and industrial manufacturing. That's a fairly diverse, and growing, set of global customers. The company also has a good trend of positive earnings surprises. Analyst earnings estimates and recommendations have also been improving. Not only does Newport's Income Statement look good, but its balance sheet does too. The company also doesn't require large amounts of capital expenditures to remain competitive. Cash flow looks pretty good as well. Newport is really as good as it looks.

Susser Holdings Corporation (SUSS - Snapshot Report)

Susser Holdings Corp operates convenience stores and distributes motor fuels in Texas and surrounding states. The company has been indicating that higher revenue for Q2 should be expected, and stock analysts have taken note by improving both estimates and recommendations. Susser has also recently announced a $15 million share repurchase program. That's about 5% of outstanding stock. Do you think management feels its stock is underpriced? You bet! The stock price of this consumer staple company has been doing very well over the last 18 months. All the corporate financial statements look good as well.

Neenah Paper Inc. (NP - Snapshot Report)

Neenah Paper produces and sells fine paper products for corporations, including writing paper, letterhead, packaging, envelopes and brochures, and technical products including tapes, labels, wall covering and image transfer papers. Needless to say the product mix is diverse and so is its worldwide customer base. The company has been reducing its debt levels and has a good record of earnings surprises (which has resulted in improving analyst estimates and recommendations). Profit margins have remained strong and NP has fairly good Price/Sales and Price/Earnings ratios.

Town Sports International Holdings Inc. (CLUB - Snapshot Report)

Town Sports International operates fitness clubs in the Northeast and Mid-Atlantic states. Insiders at this company have been buying over the last few months and that's usually a good sign. The stock price has been flying like a falcon on fire over the last 12 months. The company has been consistently surprising on earnings, and analysts are increasing their estimates and recommendations as a result. Although the P/E ratio is about average, the P/S ratio (which is a more predictive measure anyway: see Style Anomaly: Pure Value) looks pretty good.

This study provides evidence of the size anomaly and demonstrates that Small outperforms Large over the long term. Yet, remember that many reversals do occur and they are often determined by economic conditions. The rationale for the size anomaly's existence over time may lie in investors not fully realizing the potential earning power of Small Caps and, perhaps, overpaying for perceived safety. The size anomaly is another example of the market not being able to properly reflect current conditions and future expectations in current stock prices.

The size anomaly is just one of many types of investment anomalies. Other examples might include anomalies based on analyst data, insider trading and earnings surprises. To explore the world of stock investing anomalies and profitable strategies, please visit a website dedicated to their explanation and discussion: hema.zacks.com. You’ll also be able to interact with the experts. It's definitely worth a visit.

Read the full analyst report on NEWP

Read the full analyst report on CLUB

Read the full analyst report on MIND

Read the full analyst report on SUSS

Read the full analyst report on NP