We aim to discover just how a share's market capitalisation (size) has an effect on expected growth. We will show, as with research done on international markets, that portfolios created from small shares significantly out-perform all other shares and the indices over 1, 3 and 5 year periods, although risk is much higher. We will use this research to guide us which size shares we should be targeting in our portfolios.

We will test multiple periods commencing in 2000
(we are busy working on additional analysis back to 1990 for our subscribers only.) In each period we will sort the JSE by low-to-high market capitalisation (MCAP) as at 30 March, based on the most recent financials of each company at that date, be they finals or interims (this ensures fresh fundamental data is used in deriving the MCAP). We then divide the sorted list into 10 deciles and create portfolios from each decile (decile-10 is smallest stocks, decile-1 is largest stocks). We then measure each portfolios' 1, 3 and 5 year subsequent growth. Growth is measured using the last day in March of each year as start and end dates. The diagram below shows how such an excelsior would categorize the current market as at 30 March 2009:

We created five sets of deciles to measure average 5 year growth, namely 2000-2005, 2001-2006, 2002-2007, 2003-2008 and 2004-2009. There are 2 additional sets of deciles for the 1 and 3 year growths, namely 2005-2008 and 2006-2009. There is also one extra decile set for the 1 year growth, namely 2007-2008. So there are 5 sets of 5-year deciles, 7 sets of 3 year deciles and 8 sets of 1 year deciles. Decile sizes ranged from 23-30 shares depending on year. The tests have thus exposed the 1,3 and 5 year periods to the latest 2009 crash as well as the 2000 meltdown. Since there are two full boom and bust cycles in this test period it is a good indicator of strategy performance.

Finally we averaged the results for each decile (5 sets of results averaged for 5 year growth, 7 sets of results averaged for 3 year  and 8 sets averaged for 1 year growths), and produce summary findings together with analysis of decile portfolio characteristics such as risk adjusted return, volatility, base rates and total return. This ensures a holistic method of evaluating a strategies performance instead of chasing strategies with seemingly the highest growth rates.


We see confirmation of international tests, for all of 1, 3 and 5 year portfolio holding periods, that portfolios of the smallest market cap stocks (Decile-10, or 40 stocks less than R50.0 million in today's market) outperform portfolios of the largest stocks (Decile-1, greater than R10Bn in today's market) by a significant amount. However the problem with the "micro-cap" stocks in decile-10 is that they could be illiquid. They are either closely held and impossible to buy or the bid-ask spreads are so large that they make purchasing infeasible.

In fact, here at PowerStocks, we categorise the universe of "LIQUID STOCKS" as deciles 1-8 (greater than R100.0 million in 2007's market.) as the "investible market" for the private individual wishing to Strategy Index. Although it is possible for an active investor, with focus, to execute a Decile-9 strategy of "investible micro-caps", we show the effort not worth it when risk adjusted returns are taken into account versus a good indexing strategy.

It is one thing having impressive average annual growth rates, but quite another if volatility is through the roof. Here we will examine MCAP decile-portfolio growth, versus standard deviation of underlying share growth (we call this "Portfolio Deviation") together with an averaged risk adjusted return ratio (Sharpe ratio=average growth divided by standard deviation).

We see that volatility of the underlying shares that make up the decile portfolios decreases as MCAP get bigger. This implies less volatile but conservative growth with larger stocks are possible than with smaller stocks. The graphs above explain perhaps why investing in the JSE TOP-40 (via an ETF such as Satrix) is so popular, since this portfolio is effectively represented by Decile-1 (Top 10% of market by size, for 400 shares is 40 shares) which seems to exhibit the best risk adjusted return by portfolio deviation. However before we throw away our Strategy Indexing plans and dive into a Satrix-40 ETF, remember that the Sharpe ratio above relates to underlying share volatility in a portfolio, and a low Sharpe (high volatility) is not necessarily bad, provided annual growth deviation, base rates and total returns are satisfactory. So let's hold that ETF judgement till later!

We now evaluate total return delivered by a 1-year holding period strategy over the 2000-2008 time-frame. We start in March 2000 and for each MCAP Decile, we take a hypothetical R1.00 and use it to buy equal rand amounts among the underlying shares of  the portfolio. We hold the portfolio for a year, after which we rebalance it (sell everything) and repeat the process (8 times) with the funds we have over. We exclude broker fees etc. (which will be about 2% each year per portfolio, 1% for the buying and 1% for the selling.) Dividends are excluded from returns.

The total returns delivered by the Micro-caps is breathtaking, which at R75.44 is double the best strategy we have yet back-tested here at PowerStocks, namely Price/Book Decile-10 which delivered R33.71. However this is a mirage, since illiquid and high bid-ask spreads are likely to make this strategy almost impossible to attain, and the volatility would probably scare off most investors.

We therefore focus our attention to deciles 9 downwards displayed on the graph on the right. It is with interest to note that only Decile 10,9 and 6 provided greater returns than GRP (an equal-weighted index of the ALSI universe which delivered R6.78 in this backtest), whilst deciles 3,5,8 and 1 barely out-performed the ALSI. Thus the only worthwhile MCAP based decile strategies worth implementing from a total returns perspective are the "investible micro-caps" in Decile 9 (which will require a more active investing style to manage through the illiquid and bid/ask spreads) and the upper third of the small-cap category (decile 6 which is R350-R650 in to-days market).

Here we examine an important characteristic of the above 1-year holding strategy, namely its historical tendency to outperform the market as a whole. This is crucial as very few investors can stand by and be patient with a strategy whilst it is under-performing the market for extended periods (even if its known to be a superior strategy over time). For our base rates, for each of the 8 years under comparison in the previous section, we created two portfolios called GRP (an equal weighted index of the JSE universe) and ALSI which is the standard JSE index with market-cap weighting. We feel it is important for a strategy to beat BOTH these peer groups at least 66% of the time to not deter the average investor. The below table shows what % of the time during the whole 8 year test period, each MCAP-decile portfolio beat these two benchmark indices:

We see that larger shares (Decile 1,2,3) do not necessarily beat the market indices often. The base rates for deciles 1 an 2 (the top 20% largest stocks on the JSE) do not meet our criteria of 67% minimum win rate against the ALSI, with the win-rates against GRP being rather appalling. However, since GRP contains the smaller issues mostly responsible for decile 9 and 10's high growth, this is to be expected.

Regarding decile-9 we note that although it has an acceptable win rate against the ALSI (>70% of the time) it only wins against GRP less than 50% of the time. The other promising strategy, namely decile-6 (large small caps) only wins against ALSI 60% of the time, although it has a respectable 70% win rate against GRP.

Here we look at the average per-annum growth achieved by each MCAP decile portfolio over the 8 years, compared to the standard deviation of said growth to derive a risk-adjusted "Annual Growth" score. This examines volatility of the per-annum growth of the respective portfolios as opposed to the volatility of their underlying shares we looked at in a previous paragraph. It gives us a sense of the "consistency" of the annual performance of the strategy over the 8 year period.

We note with interest that decile-9  provides for very low annual standard deviation coupled with its returns, driving the Sharpe ratio to a very high 2.7. Whilst shares in decile 9 may also suffer from liquidity issues, the risk adjusted return is among the highest we have seen from backtests so far and this strategy may warrant further investigation PROVIDED the investor can devote a more active investing style as opposed to passive indexing. Decile-6 also provided "reasonable" risk adjusted return, although we are put off by the 60% base rate against the ALSI. Deciles 1 through 5 seem to be a "mixed bag" of results.

We conclude that larger market capitalised shares are not a guarantee of market out-performance. Selection of shares in an investment strategy based on size alone, excluding the bottom 20% of the market (micro caps)  provides mixed results and certainly does not provide the total-return performance of some of the other indexing strategies we track. Smaller shares in general out-perform larger shares but not to the extent that it allows for strategy formulation based on MCAP. Portfolios of larger shares seem to offer less "portfolio volatility" in terms of constituent share growth. As a final observation, apart from micro-caps, size alone is not an ideal indicator for use in an investment strategy.
 The only characteristic large size brings to the party seems to be "portfolio volatility" and we will show later how this is used to good effect in our "Large Cap" strategies.
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