Returns by Market Capitalization Over the Past Decade
Market capitalization is simply the total dollar value of all of a company’s outstanding shares of stock. It is often referred to as market cap for short. You can calculate market cap for a company by taking the current market price for a share of stock and multiplying it by the number of shares outstanding for that company. The size of a company is often measured by market capitalization and the media is routinely fascinated by which company currently has the highest market cap.
Stocks are often lumped into categories based on market cap. Those categories often include the following:
- Mega Cap (> $100 billion)
- Large Cap (>$10 billion)
- Mid Cap ($2 to $10 billion)
- Small Cap ($300 million to $2 billion)
- Micro Cap (< $300 million)
- Nano Cap (< $50 million)
These market cap size category definitions vary from source to source and can change over time. As a fat pitch value investor, I’m most interested in seeing if there is difference in returns for stocks based on market cap. Past studies have indicated that some market cap categories outperform other categories. Often small cap stocks are cited as generally outperforming large cap stocks. However, these market cap differences change over time and the performance differences may change with the business cycle.
I’m not one for really relying on past studies. I decided to do my own backtest. I used the data and backtesting tool provided by StockScreen123. This backtest will be the first one of a series of backtests that differ from my Richard Tortoriello inspired backtests. I’ve designed the filtering criteria for this backtest specifically for individual investors and with a focus on enhancing data quality. The filters include the following criteria:
- No OTC stocks. Stocks not traded on the New York Stock Exchange, NASDAQ, or American Stock Exchange markets are excluded. The quality of fundamental stock data for OTC can be somewhat lower and less timely that that for stocks traded on major exchanges.
- No ADRs. Fundamental data for foreign American Depositary Receipt can include errors due to currency exchange, different accounting standards, and share count.
- Exclude miscellaneous financial services industry. This is mainly to filter out closed-end funds.
- Liquidity test. The average daily total amount traded over the past 60 trading days must be larger than $100,000. This amount was selected so that a $1 million dollar portfolio could hold 100 positions and that each new $10,000 position would not exceed 10 percent of a day’s trading volume. The liquidity test also ensures that the backtest has reliable market price information for any of the stocks that are being tested.
- Market Cap > $50 million. Nano cap stocks are excluded to help improve data quality. This filter also ensures that positions in a modest sized portfolio never exceed one percent of shares outstanding or the available float for a company.
- Price > $1. True penny stocks are excluded due to various information issues and manipulation of these stocks.
After these filters are applied, we are left with approximately 3,000 to 4,000 stocks. These are then ranked by the criteria being tested; in this case, we are testing market cap. The top 20 percent of stocks ranked by market cap is placed in the first quintile and the next 20 percent in the second quintile and so forth until we have five portfolios of stocks. The portfolios are rebalanced every 12-months and compounded annually to more realistically replicate what an individual investor might be expected to do to avoid higher short-term capital gains tax and trading costs. To help ensure that the test is not impacted by seasonal or statistical effects, the backtest is also started at four different points during the calendar year. The results of the quarterly tests are used to calculate the average excess returns for each quintile. The results for the 10-year market cap backtest are as follows:
Market Cap: Average Excess Returns vs. Universe
Market Capitalization: Rolling 3-Yr Periods Excess Returns vs. Universe
As you’d expect, the largest 20 percent of stocks underperformed the other stocks by 1.89 percent. The surprising result was the outperformance of the second quintile. The second quintile currently includes stocks with market caps between $4.2 billion and $1.5 billion. These are basically mid cap stocks. The CAGR of the second quintile from December 31, 2001 to January 1, 2012 was 8.48% and the annual average outperformance of the four seasonal starting points was 0.34%.
The one thing I didn’t expect was the underperformance of the bottom quintile, the micro cap stocks. However, this underperformance might have more to do with the relatively short 10-year backtest. If you look at the rolling 3-Yr periods excess returns versus the universe chart, the red line represents the bottom quintile. From 2003 to about the third quarter of 2005, the micro cap category actually outperformed the universe. The micro caps really get hit during the financial crisis and that is the main reason they underperform in this backtest.
The micro cap category results provide a good reminder that past performance is no guarantee of future results. My goal with this backtest and future backtests is only to identify potential spots to look for fatter pitches.
Do prefer stocks from a certain market cap category? If so, please share which category you prefer and why. I’m also interested in your feedback regarding the 6 filtering criteria I used for this backtest. I plan on using those filters for future backtests, so it’s important that I get your feedback now. Please share your thoughts in the comments section below.