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Capitalization matters

Few people know it, but there’s a very simple way to beat the profitability of the main American index, the S&P500.

The key property of this index is that it consists of more than 90% stocks of companies with large and mega capitalizations. But another property is that the weight of companies in this index is proportional to their capitalization. That is, we have an index instrument whose capitalization is significantly skewed towards Mega Caps.

snp500 companies pie chart

Half of the capitalization of the S&P500 is accounted for by just 6 of 505 tickers.

And the main property of large and mega capitalizations is that it’s extremely difficult for them to grow ahead of the average market dynamics, due to the high base effect and the real world’s inability to endlessly consume an increasing number of goods and services produced by those companies. The main rule is that the smaller the company, the easier it is to scale with a high-quality business model because there’s still a lot of potentially unoccupied market space. In other words, smaller companies have a legal cheat code over large companies called the “low base effect”.

And then the question immediately arises: can we increase the profitability of our investments without buying large and mega companies that have a hard time growing because they actively resist the physical limits of the space around them? The answer is obvious: Yes, we can. The easiest way to verify this is to look at the equally weighted S&P500 index, where companies are not weighted in proportion to their capitalization, but simply by their share. In such an index, there won’t be a gigantic predominance of large capitalizations over smaller ones. Portfoliovisualizer.com will help us backtest this idea.

Let’s compare SPY (classic S&P500) and RSP (equally weighted S&P500):

We can see a small outperformance of ~1% over the last 18 years. But I wouldn’t call 18 years a sufficient data sample to confirm the existence of a performance effect from smaller capitalizations.

Ycharts has data for a 30-year period:

S&P500 Classic: +10.01% CAGR
S&P500 Equal Weighted: +10.9%  CAGR

As you can see, the performance of ~1% remains over a longer period of time.

I have come across studies of synthetic equally weighted indexes since 1926, where performance has remained for a 90-year period.

But let’s tweak our idea a bit.

 

Mid Cap Advantage

What if we abandoned the S&P500 index altogether because each company that is included in the index is inherently very large? S&P have already thought about this and created an index for good companies with capitalizations insufficient to get into the S&P500 and called it the S&P MidCap 400 Index.

This idea is very easy to backtest in Portfoliovisualizer, as we have a wonderful IJH ETF that replicates the composition of this index:

We can see the preservation and strengthening of performance over the S&P500 already at + 2.5% for 20 years.

Let’s see if the performance continues over a longer period of 50 years:

We can see that the outperformance remains at the level of +1.5%, which is more than for the S&P500 Equally Weighted.

If this data is not enough for you to see the presence of premiums for smaller capitalizations, then let us expand the boundaries of the model. If the premium of smaller capitalizations really exists, it must exist in every country’s market, since the factor has a physical basis and is universal in nature.

Let’s look at the reports on China and Japan by MSCI, which deals with index investing in markets around the world.

MSCI Japan excess of medium over large since 1998: +2.29% per year (5.06% vs. 2.77%).
Link to Large Capitalization Report
Link to the Middle Capitalization Report

MSCI China excess of Medium over Large since 1994: +2.37% per year (5.23% vs. 2.20%).
Link to the Large Capitalization Report
Link to the Middle Capitalization Report

Important: pay attention to the “since” column, because for some reason the graphs are not displayed in pfd for the entire time period.

 

Small Cap Outperformance

This immediately raises a question: can we still improve our results by taking small-cap companies rather than mid-cap ones? It’s possible, but not quite directly because of one feature:

Small capitalizations (red line) have a very stable advantage over large capitalizations (green line), but there’s no very stable advantage over medium capitalizations (blue line). The reduction in advantage is very easy to explain. The thing is, a medium company is about 40 times smaller than a large one, and a small company is only 5 times smaller than a medium one (data from finviz.com). For this reason, it turns out that most of the low base effect over large capitalizations occurs in medium-sized companies, which are not very different in size from small companies. This hypothesis is supported by the fact that we can see an increasing performance of + 1.15% for micro-capitalizations (orange line), which are already 30 times smaller than medium capitalizations.

In the MSCI indexes, there’s no separation between micro and small. A company of any size can be included in the small index.

MSCI Japan excess of Small over Medium since 1998: +1.38% per year (6.44% vs. 5.06%).
Link to the Small Capitalization Report

MSCI China excess of Small over Medium since 1994: +1.46% per year (6.69% vs. 5.23%).
Link to the Small Capitalization Report

Links to the MSCI report on Europe. Indexes between capitalizations are not synchronized in time from the beginning and do not lend themselves well to comparative testing.
Large. Medium. Small.

Nonetheless, premium differences of several % by capitalization can be observed here as well.

Is it still possible to improve profitability results? It’s possible, but this is already beyond the limits of passive index investing. To do that, you need to create your own security indexes that further exploit the small capital advantage that index funds do not have because of their large positions. But that’s a topic for another conversation.

To summarize: if you are a private investor with a small amount of money, I strongly believe that you should only consider small companies because the only advantage large companies have is their capital capacity and liquidity. Leave this game to the big guys who are forced to play it because they feel very cramped in the more profitable minor league and all of their profitability will be eaten up by slippage when entering and exiting positions with very large volumes. Let’s maximize our advantage of small capital.

It would be great if you could share your remarks or questions regarding this article. Please leave a comment below this article or contact me here. I always answer all questions.

Good trading to everyone and see you in the following articles!


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3 thoughts on “The Easiest Way to Beat the S&P500

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