Understanding Investment Anomalies: Submarkets

Here is something you might not know about investing.

There are submarkets inside the stock market as you know it.

These submarkets have underperformed and outperformed the market as a whole.

According to Eugene Fama, the 2013 recipient of the Nobel Prize in Economics and Finance, along with four other recipients of the Prize, the stock market processes information very efficiently.

It reflects market factors immediately, before anyone can react to the information.

Asset managers who say they are able to anticipate market movement are speculators and have no legitimate research basis for making this claim.

Markets are an amalgamation of submarkets, which simply means there are categories of companies within the overall list of markets that perform different than the market as a whole.

Here is an example.

The Center for the Research of Securities Prices (CRSP) database, tracks over 32,000 publicly traded stocks from inception dating back to 1926.

If you had invested $1 in the CRSP database, in 1926, it would have grown to $5900. 

This is what most people refer to, when they talk about the stock market.

It is the market as a whole.

Most have heard of the S&P 500. This is the 500 largest stocks in the CRSP database using FMV as the measure. Since 1926, $1 grew to $7200. This is a .4% higher return than the market as a whole.

The S&P is a submarket of the total market, and demonstrates the difference between investing in the market as a whole, as compared to a submarket over the same period of time.

Dimensional Funds, one of the largest mutual fund families in the world was formed in 1981, to explore and capture these submarket dimensions, submarkets comparable to the S&P 500.

Using the research of Fama, Miller, Markowitz, Sharp and Merton, Dimensional identified and captured these submarkets, which are often referred to as anomalies. They discovered three that are the cornerstone of their investment strategy.’

Take out a piece of paper and draw a circle.

This circle represents over 7800 domestic stocks.

These are 100% of all the stocks Dimensional has determined meet a stringent criteria for growing and protecting capital.

Let’s look at the three anomalies.

The first one is based on the size of a company – the capitalization value. We can determine this simply, by multiplying the stock price times the number of shares held by investors.

If we rank all of the these stocks and find the median – 50% will be larger than the median and 50% will be smaller than the median. We will call these large cap and small cap stocks.

Looking at the CRSP data for the these stocks.

One dollar invested in large Cap grew to $3200 from 1926 to 2017.

Dimensional determined that 54% of the time, small cap out performed large cap, using one year rolling data. There are 1045 one year periods from January 1926 through December 2017.

If we look at the five year rolling average, small cap out performed large cap 64% of the time. Looking at 10 year rolling periods, the percentage increases to 72% and it is 85% when examining the 900 – 15 year rolling periods.

Clearly, small cap has provided higher returns than large cap more often.

The same is true of value.

This is measure by looking at the net worth of a company – assets minus liabilities.

This can be called book value. If we divide this amount by the FMV of the stock, the ratio can be compared for every stock in the database. The higher the ratio, the closer the liquidation value is to the FMV.

Companies with a lot of assets, buildings, equipment, inventory have larger book value than a technology company with only computers, desk and patents.

Research has shown, high value companies have outperformed companies with small book to value ratios. Using the one year rolling average, value beats growth 57% of the time.

The five year average has been 65%, the ten 78% and the 15 year 92% of the time. The evidence makes it clear that value companies often provide higher return to the investor than growth companies.

The last anomaly is profitability. Here we measure the profitability of a company using a modification of the reported earnings every quarter.

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