VIOV - The Return Of The Size-Value Premium

2023-05-08 11:37:04 ET

Summary

• Some claim that the size-value premium is diminished or gone.
• The risk-based theory of additional returns is incomplete.
• Once we remove 'lottery-like' stocks we rediscover the size-value premium.

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In 1993 Kenneth R. French and Eugene F. Fama published the paper, Common risk factors in the returns on stocks and bonds , which came to conclusion that there is a significant size and value premium. Since then, many practitioners and academics have questioned the robustness of these factors. Looking at a trailing 10-year chart of the Vanguard S&P Small-Cap 600 Value Index Fund ETF ( VIOV ) and the S&P 500, you can see why many might feel this way.

Is size and value premium is dead? Let’s study this more carefully.

Risk-Based Premium Theory

Common sense would tell you that higher risk should be accompanied by a higher potential reward. The payout on correctly guessing the number on a roulette wheel should be far greater than guessing the color it will land on.

Following this logic, smaller stocks and low price-to-book ratios (which are common among distressed firms) carry more risk and should thus deliver more potential return. When taken as a whole, investors should be rewarded with a little additional return for holding small value stocks as opposed to holding large growth stocks. This seems logical and rational. But it doesn't seem to be working this way. Why?

Lottery Preference

Another finding is that investors are not always rational. When there are stocks with the potential for an extreme return, they misprice the opportunity. The paper entitled, Lottery Preference and Anomalies , discusses a different effect where investors actually show a preference for high-risk investments and this leads to lower future returns.

To illustrate, if you were asked to guess a number between 1 and 100, the payoff should be slightly above 100:1 to make it worth your while. But gamblers show a preference for these high risk and high reward stakes and they may be inclined to keep playing even if the odds were as bad as 50:1. You might get lucky but if you were to play the game long enough you would see the error of your ways.

The same is true with stocks which have the potential for ‘lottery-like’ returns. Investors price the risk-to-reward scenario so it is no longer efficient or rational.

Conflicting or Complimentary Theories?

These two ideals need not be mutually exclusive. Generally speaking you may receive a higher premium for taking on higher risk... to a point. And then it flips and you start to receive lower returns for higher risk due to the 'lottery effect'.

If that is true, then we merely need to separate them into two groups and invest in the rationally priced pool of stocks to get our size and value premium.

A More Appropriate Value Factor

Before we separate our stocks into lottery and non-lottery categories, we need to discuss which value factor we will use.

The Fama and French paper used the price-to-book factor. I find this suboptimal due to the changing nature of companies. Many firms today are service or tech based and do not require the same asset base to earn profit and revenues. As well, I do not want to use the price-to-earnings ratio as many small companies are not profitable and it would exclude many firms we want to grade.

Instead, I propose using a price-to-sales or price-to-cashflow factor as our proxy for value. In this example I will use price to sales.

Defining Lottery Stocks

So how do we define 'lottery stocks' in the smaller sized market cap universe? There are a couple of ways but I will use the following single rule:

• Negative free cash flow = lottery stock

The reason I feel this way is that stocks which do not have free cash flow are often 'story stocks'. They have a plan but have not yet been able to execute. If they can turn a profit, they might catapult in price. But they might also struggle and keep diluting shares to raise capital until they throw in the towel.

Price to Sales Test

First, we want to run a factor backtest (using the quarterly price to sales ratio) on all microcap and smallcap stocks. I have added a modest liquidity filter so as not to skew the results.

The test will continually sort stocks into one of five portfolios based on the price-to-sales ratio. The first red bar is our Russell 2000 benchmark. The next blue bar is the portfolio with high price-to-sales stocks. And the teal bar on the far right is the portfolio with the lowest price-to-sales stocks.

Chart of P/S Ratio Trailing 10 Years (All Smaller Stocks)

There is very little difference between the various portfolio sorts. I propose that this is because we have lottery and non-lottery stocks mixed in. I will remove the lottery stocks, or those with negative free cash flow, and run the test again.

Chart of P/S Ratio Trailing 10 Years (Positive FCF Stocks)

Suddenly the value premium is evident. We are once again compensated for taking on more value risk once we remove the 'lottery stocks' where gamblers are pricing the opportunity too high.

The main takeaway here is that the smallcap value funds include good risk and bad risk. If we remove the bad risk (negative free cash flow stocks) we are left with a strong size and value premium.

Analyzing VIOV ETF

The Vanguard S&P Small-Cap 600 Value ETF has 457 holdings. I analyzed the 60 stocks with the most weight which made up almost one-third of the funds weighting. I checked to see how many of these stocks had positive free cash flow over the past quarter and trailing 12 months.

• Only 40 out of the 60 stocks passed the free cash flow test.

Next I took the 60 stocks with the smallest weighting and performed the same test.

• Only 36 out of 60 passed the free cash flow test.

Therefore, it would seem that less than two-thirds of the stocks in the VIOV ETF have positive free cash flow over the past quarter and trailing 12 months. At least according to my sampling. This is roughly on par with the number of stocks passing out of the entire S&P 600.

This is a shame. One-third of the stocks are 'lottery stocks' in my eyes and are pulling the value index down.

Creating a Better Smallcap Value Index

For argument sake, let us construct a theoretical index and compare it to the S&P Smallcap 600 Pure Value index. Our index will have 250 stocks with the lowest price-to-sales ratio in the S&P 600 where the free cash flow is also positive. We will rebalance and reconstitute every 3 months.

The returns are double with less drawdown.

Summary

To me, it is obvious that if we are to harvest the smallcap value premium, it is important to distinguish the high risk lottery stocks. As of now, it is hard for me to recommend ETFs such as VIOV which lump good risk with bad risk together which will result in an inconsistent size-value premium. If 80% of the stocks in the fund have positive free cash flow, I would expect the fund to outperform. If 50% of the stocks have positive free cash flow, I would expect the fund to underperform. So until they start recognizing the subset of 'lottery stocks', I would not recommend VIOV as an efficient way to harvest the size-value premium.

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