B
Bryan
70 Times Better Than the Next Microsoft
By Bill Barker July 5, 2007
2
Recommendations
I recently found this chart from the ever-helpful moneychimp.com:
Value
Growth
Large Cap
12.4%
9.6%
Small Cap
15.4%
9.2%
Those are historical returns from 1927 to 2005, not adjusted for inflation.
The terms "value" and "growth" are taken from data from Fama and French,
whose work is highly respected.
That's a persuasive case for putting small-cap value stocks to work in your
portfolio. (We'll get to just how persuasive later.) And you've probably seen
plenty of other data showing that small caps outperform large caps and value
outperforms growth. Why, then, doesn't small growth outperform large growth?
And why does small growth, on average, end up being the worst choice for your
money?
Moneychimp.com offers a theory, and I think it's worth seriously
entertaining, at least when it comes to how you invest in small caps. Just
think about how investors might mentally categorize large- and small-cap
value and growth companies. It might look something like this:
Value
Growth
Large Cap
Well-known, boring businesses
Well-known, exciting businesses
Small Cap
Unknown, boring businesses
The next Microsoft is in here somewhere!
Thanks, Moneychimp. You're on to something.
What do value and growth look like?
What's the price difference between what might be "the next Microsoft" and
the unknown and boring? Let's look at the data.
There's never been an official ruling on what separates "value" from
"growth." There are dozens of ways to make those distinctions, and the data
that Fama and French produce comes from their own method of sorting out what
makes a value stock and what makes a growth stock. Let's look at a more
accessible listing of stocks to give you an idea of what value and growth
look like according to recent data. We'll take two of the largest holdings
from each of the Vanguard small- and large-cap value and growth index funds:
Price-to-Book
Price-to-Earnings
Large-Cap Value (average)
2.4
14.9
Wells Fargo (NYSE: WFC)
2.6
14.0
Pfizer (NYSE: PFE)
2.5
10.0
Large-Cap Growth (average)
4.2
22.4
Schlumberger (NYSE: SLB)
9.0
26.1
Disney (NYSE: DIS)
2.1
16.2
Small-Cap Value (average)
1.9
20.2
AnnTaylor Stores
2.5
18.5
Ryder System
1.9
13.3
Small-Cap Growth (average)
3.8
30.9
ITT Educational Services (NYSE: ESI)
53.1
40.3
Stericycle (Nasdaq: SRCL)
6.4
36.8
These companies aren't selected to imply that any one or two is likely to do
better than another over time. Instead, they're intended to show you what
some of the larger players look like when you compare their price with both
their book value and their earnings. Obviously, to justify their prices,
those companies categorized as "growth" need to grow their earnings much
faster than the companies in the value quadrants.
The numbers attached to these small-cap growth companies are particularly
startling. That's not to say that ITT Educational Services and Stericycle are
necessarily overpriced, nor that they won't grow their earnings sufficiently
to be good investments from here. But to the extent that they represent the
expectations built into their other brethren in the small-cap growth field,
we can see why the returns for the quadrant as a whole end up disappointing
investors.
Taken as a whole -- as measured by thousands of companies, not just two --
small-cap stocks will be more inaccurately priced than large caps in the
market, but not necessarily better-priced. The inaccuracies work both ways.
Those that are historically overpriced (small-cap growth) tend to be more
overpriced than their large-cap brethren, and those that are underpriced
(small-cap value) can be more so than their large-cap cousins -- though as a
group, they're not at the moment, at least as measured by the price/earnings
ratio. They still look cheaper on a price/book metric.
What's the cost?
The rewards of being aligned with the right quadrant instead of the wrong
one over 78 years are absolutely staggering. Compounded over those 78 years,
$100 would translate to:
Value
Growth
Large Cap
$898,967
$130,165
Small Cap
$7,307,903
$103,626
Is 78 years a relevant investment period? Well ... kind of. It's just
slightly longer than an average American life span. So the difference between
small-cap value and small-cap growth over a lifetime has been a multiple of
more than 70 times the end result. That's right: 70 times. (So get started
investing early, and start your kids' accounts now!)
There are literally thousands of companies in that small-cap value quadrant
that you should be concentrating on, none of which can possibly be described
as "the next Microsoft." They might not carry the wallop of a potential
Microsoft over the short term, but over many decades, and taken as a group
.... wow.
We spend every day looking for the next not-exactly-Microsoft at Motley Fool
Hidden Gems. We closely follow a manufacturer of clothing labels and a
producer of components for manufactured homes. (Both are market-beaters.) But
you don't have to be an expert at finding the best ones in that quadrant,
because the average returns have been so monumental.
Remember that the next time you hear about how somebody has found the next
Microsoft.
Hidden Gems actually does have a terrific record of finding the
better-performing companies in the small-cap arena. Take a free one-month
guest pass of our newsletter to help you find small-cap winners. There's
absolutely no obligation.
This article was originally published on Jan. 12, 2006. It has been updated.
Bill Barker owns none of the companies mentioned in this article. Microsoft
and Pfizer are Inside Value recommendations. Disney is a Stock Advisor
recommendation. The Fool has a disclosure policy.
By Bill Barker July 5, 2007
2
Recommendations
I recently found this chart from the ever-helpful moneychimp.com:
Value
Growth
Large Cap
12.4%
9.6%
Small Cap
15.4%
9.2%
Those are historical returns from 1927 to 2005, not adjusted for inflation.
The terms "value" and "growth" are taken from data from Fama and French,
whose work is highly respected.
That's a persuasive case for putting small-cap value stocks to work in your
portfolio. (We'll get to just how persuasive later.) And you've probably seen
plenty of other data showing that small caps outperform large caps and value
outperforms growth. Why, then, doesn't small growth outperform large growth?
And why does small growth, on average, end up being the worst choice for your
money?
Moneychimp.com offers a theory, and I think it's worth seriously
entertaining, at least when it comes to how you invest in small caps. Just
think about how investors might mentally categorize large- and small-cap
value and growth companies. It might look something like this:
Value
Growth
Large Cap
Well-known, boring businesses
Well-known, exciting businesses
Small Cap
Unknown, boring businesses
The next Microsoft is in here somewhere!
Thanks, Moneychimp. You're on to something.
What do value and growth look like?
What's the price difference between what might be "the next Microsoft" and
the unknown and boring? Let's look at the data.
There's never been an official ruling on what separates "value" from
"growth." There are dozens of ways to make those distinctions, and the data
that Fama and French produce comes from their own method of sorting out what
makes a value stock and what makes a growth stock. Let's look at a more
accessible listing of stocks to give you an idea of what value and growth
look like according to recent data. We'll take two of the largest holdings
from each of the Vanguard small- and large-cap value and growth index funds:
Price-to-Book
Price-to-Earnings
Large-Cap Value (average)
2.4
14.9
Wells Fargo (NYSE: WFC)
2.6
14.0
Pfizer (NYSE: PFE)
2.5
10.0
Large-Cap Growth (average)
4.2
22.4
Schlumberger (NYSE: SLB)
9.0
26.1
Disney (NYSE: DIS)
2.1
16.2
Small-Cap Value (average)
1.9
20.2
AnnTaylor Stores
2.5
18.5
Ryder System
1.9
13.3
Small-Cap Growth (average)
3.8
30.9
ITT Educational Services (NYSE: ESI)
53.1
40.3
Stericycle (Nasdaq: SRCL)
6.4
36.8
These companies aren't selected to imply that any one or two is likely to do
better than another over time. Instead, they're intended to show you what
some of the larger players look like when you compare their price with both
their book value and their earnings. Obviously, to justify their prices,
those companies categorized as "growth" need to grow their earnings much
faster than the companies in the value quadrants.
The numbers attached to these small-cap growth companies are particularly
startling. That's not to say that ITT Educational Services and Stericycle are
necessarily overpriced, nor that they won't grow their earnings sufficiently
to be good investments from here. But to the extent that they represent the
expectations built into their other brethren in the small-cap growth field,
we can see why the returns for the quadrant as a whole end up disappointing
investors.
Taken as a whole -- as measured by thousands of companies, not just two --
small-cap stocks will be more inaccurately priced than large caps in the
market, but not necessarily better-priced. The inaccuracies work both ways.
Those that are historically overpriced (small-cap growth) tend to be more
overpriced than their large-cap brethren, and those that are underpriced
(small-cap value) can be more so than their large-cap cousins -- though as a
group, they're not at the moment, at least as measured by the price/earnings
ratio. They still look cheaper on a price/book metric.
What's the cost?
The rewards of being aligned with the right quadrant instead of the wrong
one over 78 years are absolutely staggering. Compounded over those 78 years,
$100 would translate to:
Value
Growth
Large Cap
$898,967
$130,165
Small Cap
$7,307,903
$103,626
Is 78 years a relevant investment period? Well ... kind of. It's just
slightly longer than an average American life span. So the difference between
small-cap value and small-cap growth over a lifetime has been a multiple of
more than 70 times the end result. That's right: 70 times. (So get started
investing early, and start your kids' accounts now!)
There are literally thousands of companies in that small-cap value quadrant
that you should be concentrating on, none of which can possibly be described
as "the next Microsoft." They might not carry the wallop of a potential
Microsoft over the short term, but over many decades, and taken as a group
.... wow.
We spend every day looking for the next not-exactly-Microsoft at Motley Fool
Hidden Gems. We closely follow a manufacturer of clothing labels and a
producer of components for manufactured homes. (Both are market-beaters.) But
you don't have to be an expert at finding the best ones in that quadrant,
because the average returns have been so monumental.
Remember that the next time you hear about how somebody has found the next
Microsoft.
Hidden Gems actually does have a terrific record of finding the
better-performing companies in the small-cap arena. Take a free one-month
guest pass of our newsletter to help you find small-cap winners. There's
absolutely no obligation.
This article was originally published on Jan. 12, 2006. It has been updated.
Bill Barker owns none of the companies mentioned in this article. Microsoft
and Pfizer are Inside Value recommendations. Disney is a Stock Advisor
recommendation. The Fool has a disclosure policy.
