What it means
Two separate ideas sit inside the term. The first is size, measured by market capitalisation, which is the share price multiplied by the number of shares in issue.
The second is value, usually identified by a low ratio of price to book value, which compares the share price with the accounting value of the company's net assets per share. Academic research on asset pricing identified size and value as two factors that have explained part of the differences in stock returns over long periods.
In some studies, small value stocks have earned higher average returns than large growth stocks. These results are historical averages, and there have been long periods in which the pattern did not hold.
Why would such shares earn more? One argument is that they are riskier, since small and cheap companies are often more fragile, so investors demand a higher return for holding them.
Another is behavioural, suggesting that investors overpay for exciting growth companies and neglect unglamorous ones. In practice, investors can access small value stocks through index funds and exchange-traded funds that screen for the two characteristics.
The funds usually hold hundreds of shares to spread the risk of individual failures. Costs and liquidity should be reviewed, because trading small shares is generally more expensive than trading large ones.
A common nuance is the value trap, which is a share that looks cheap because its business is deteriorating and it deserves its low price. Careful analysis of debt, cash flow and the reasons for the discount helps separate real bargains from traps.
Patience is also essential, since cheap shares can stay cheap for years. For corporate managers the same idea matters in reverse.
A small company trading well below its book value may attract takeover interest, so boards should know what their shares are worth to a buyer as well as to the market.
In practice
Real-world examples.
Example
A fund manager screens the stock market for companies with a market value below $2,000,000,000 and a price-to-book ratio under 1.0. The screen returns 80 companies that she then researches individually. She keeps only those with manageable debt and positive cash flow.
Example
A private equity analyst notices that a small listed packaging company trades at 0.75 times book value. After reviewing the accounts, he finds the market has overreacted to one lost customer. The firm proposes a takeover at a premium that still values the business well below its assets.
Example
A pension scheme adds a small value index fund to its equity allocation to diversify away from large growth companies. The trustees accept that the fund may trail the wider market for several years. They review it over a full market cycle.
Formula
Calculation
Price-to-book ratio = Share price / Book value per share
Market capitalisation = Share price x Number of shares
Suppose a company has 50,000,000 shares in issue trading at $12 each, and its balance sheet shows shareholders' equity of $800,000,000. Market capitalisation = 12 x 50,000,000 = $600,000,000. Book value per share = 800,000,000 / 50,000,000 = $16. Price-to-book = 12 / 16 = 0.75, which means the market values the company at 75 cents for every dollar of net assets on its books.Case study
Seen in the real world.
Stonebridge Capital is an illustrative, fictional fund that ran a small value strategy. After a market downturn, its screen identified a small industrial firm trading at 0.6 times book value with little debt.
The fund's analyst visited the company, read its filings and concluded that the downturn had hit orders temporarily but had not damaged its factories or customer base. The fund bought gradually over several months to avoid pushing the price up.
Over the following three years the firm's earnings recovered and its share price roughly doubled. The illustrative lesson is that this style needs research and patience, since the shares were unloved for a long time before the payoff arrived. Stonebridge also limited each holding to a small share of the fund, so one failure could not do serious damage.
Watch out
Common mistakes.
- Treating every cheap share as a bargain, when some are cheap because the business is in real decline.
- Ignoring liquidity, so that trying to sell a large holding moves the price against the investor.
- Expecting quick results, when small value stocks can underperform for years before delivering their historical premium.
Questions
People also ask.
How small is small?
There is no fixed rule, but the term usually refers to companies whose market value is a fraction of the largest listed businesses, and index providers use their own cut-offs.
Is low price-to-earnings the same as value?
Not exactly, because value can be measured by price-to-book, price-to-earnings, price-to-sales or other ratios.
Are small value stocks riskier?
They are generally more volatile than large stocks, and the extra return is often seen as compensation for that risk.
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