Seeking Advantage (Sep 2017)

SEEKING ADVANTAGE
Focusing on the Underlying Drivers of
Excess Returns Most Evident in Smaller
Companies to Optimise Investment
Portfolios for Return and Risk

Martin Pretty, CFA

September 2017

Equitable Investors Pty Ltd (ACN 120 965 979) is a Corporate Authorised
Representative (No. 001256627) and Martin Pretty is an Authorised Representative
(No. 001256674) of Glennon Capital Pty Ltd (AFSL No. 338567)

Equitable Investors Pty Ltd is trustee of the Equitable Investors Dragon y Fund.

Equitable InvestorsDragon y Fund willtypically be focused onmicrotomid
caps. Itsinvestmentuniverse isnotde ned by company size, however.
Equitable Investors' investmentphilosophy and processseeksoutattractive
investmentcharacteristicsand marketinef cienciesthattend tobe more
prominentamong smaller rms.
In this paper we firstly set out the case for investing in smaller companies, including micro
caps, once you filter out low quality companies.
But rather than accepting market cap size as a factor unto itself, we consider this Small Cap
Effect as a proxy for several underlying factors that are highly correlated with size. We then
consider market inefficiencies that are likely contributors to the Small Cap Effect and are key
considerations in Equitable Investors’ search for attractive investments.
We will discuss:
➔ The Small Cap Effect - excess returns can be found in small stocks
➔ The Neglected Firm Effect - less researched firms have higher risk-adjusted
returns
➔ Information Assimilation - it can take time for information to be priced in
➔ Alignment of Interest - managerial ownership leads to improved performance
➔ Constructive & Activist Investment - influential investors can enhance
value
➔ Liquidity - excess returns in smaller companies may compensate for illiquidity
➔ Valuation - Price Matters - cheapest small caps outperform glamour stocks
➔ Correlation - micro caps offer diversification benefits
The Small Cap Effect - “Control Your Junk”
The tendency for the ordinary shares of smaller companies to outperform larger companies,
given the same level of risk, was first measured in 1978 by University of Chicago academic
Rolf Banz. It was challenged on several fronts over the years but further research has shown
that it holds, once you control for the quality of smaller companies.
If you “control your junk”, a research paper drafted in 2015 by leading US quantitative
investment firm AQR found (Asness et al), “a significant size premium emerges, which is
stable through time, robust to the specification, more consistent across seasons and
markets, not concentrated in microcaps, robust to non-price based measures of size, and not
captured by an illiquidity premium.”
Equitable Investors | Seeking Advantage August 2017 Page 2 of 14

“Quality”, for this study, was measured by the Gordon Growth Model, which says value is
determined by profitability, the dividend payout ratio, risk and growth. Figure 1, below, shows
average excess returns over the period from July 1957 to December 2012, with the highest
quality, smallest stocks delivering the greatest returns and the lowest quality “big” stocks
producing the lowest returns.
Figure 1: Excess Returns of Portfolios sorted by market cap (size) and quality (US equities)
Source: Asness et al, “ Size Matters, If You Control Your Junk”
Importantly from Equitable Investors’ Australian-based perspective, Asness et al reviewed
international markets and found a boost to excess returns in Australian small companies,
in-line with the global experience, as set out in Figure 2.
Figure 2: Change in Small Company Excess Returns from Controlling for Quality (using four
size measures)
Source: Asness et al, “ Size Matters, If You Control Your Junk”

The Neglected Firm Effect

Only ~8% of stocks listed on the ASX have a market capitalisation greater than $1 billion,
based on August 2017 data. Just on 70% of ASX listings have market caps of less than
$100m. But most of the total aggregate market capitalisation is captured by that 8% minority.
This is evident from free-float adjusted market capitalisation data for MSCI indices:
● MSCI Australia Large Cap Index has 30 constituents representing 70% of the market
● MSCI Australia Small Cap Index has 151 constituents representing 14% of the market
● MSCI Australian Micro Cap Index has 440 constituents representing 1% of the market
If treated as a single stock, the MSCI Australian Micro Cap Index would rank about 9th in the
Australian market by capitalisation (at the time of writing).
This means investors with scale, such as large institutions, find it difficult to deploy capital
with smaller stocks and, therefore, may not focus on this part of the market or may be absent
from the market. It is argued that this could distort the cost of equity capital for small caps.
It also means sell-side analysts are less likely to research small firms: their largest clients
aren’t interested; lower volumes of share trading for small firms reduces the opportunity for
their broker colleagues to generate trading revenue; and the typically size-based fees earned
by their corporate advisory colleagues are less attractive.
Figure 3: % of ASX-listings with no research coverage (in Thomson Reuters database)
No research
coverage for:
84% of micro-caps
OR
61% of all stocks
>$10m market cap
Source: Thomson Reuters,
Equitable Investors
Studies have shown that stocks that are less researched deliver greater risk-adjusted returns
than stocks receiving greater focus from analysts.
A 2008 paper by Australian academics Bertin, Michayluk and Prather, “Liquidity issues
surrounding neglected firms”, considered neglect as either low analyst coverage or narrow
dissemination of earnings announcements, and concluded based on data for 1,544 US firms
that “neglected firms, by whatever neglect construct, are much less liquid than their
counterparts, and thus the observed return premium is a logical result.”

Information Assimilation
In the main we accept that markets price in known information relatively efficiently. However,
information in the public domain is not always widely digested or assimilated and understood.
While the information may exist, it may not have been widely disseminated; or it may be
widely disseminated but a broad base of investors may not have the additional knowledge to
understand the materiality of one piece of information among many.
The smaller a company is, the less likely it is able to broadly disseminate new information;
and the less likely that a broad base of investors understand the context of that information.
A European study measuring excess returns following earnings surprises compared the
outcome before and after the adoption of wire services (or news agencies) to disseminate
news. As set out in Figure 4, it showed the new information was more rapidly priced in after
the adoption of wire services with stronger initial reactions and lower post-earnings price
“drift”. Figure 4 also demonstrates that even with broader dissemination, it still takes time for
markets to fully react to material new information.
Figure 4: Excess returns from top & bottom surprises before & after adoption of wire service

Source: News Dissemination and Investor Attention (Boulland, Degeorge & Ginglinger, May 2016)
Even at the macro level, a 2017 study by Columbia University academics Calomiris &
Mamaysky studied news flow and pricing in 51 stock markets and concluded that “Economic
and statistical significance are high and larger for year-ahead than monthly predictions” - ie
rather than immediately re-pricing, markets take time to adjust to new information.

Alignment of Interest
Logic says that the managers and directors most aligned to maximising shareholder value will
be those with a considerable portion of their wealth tied up in equity in the business they are
involved in.
A recently-published research paper reconfirmed historical studies that also showed
managerial ownership leads to an improved performance. This January 2017 paper, Managerial
Ownership, Board of Directors, Equity-based Compensation and Firm Performance: A
Comparative Study Between France and the United States, by Bouras & Gallali, found that
performance reached a maximum level at a managerial ownership level of 21.4% in the US.
The flip-side, however, is that the report found that as managerial ownership continues past
this point, entrenchment appears to become an issue.
A study this author undertook in October 2012, for Investorfirst Securities, identified 38
ASX-listed companies with a CEO entitled to a larger annual dividend than their reported
remuneration. Those 38 companies had achieved an average total return of 72% over the
previous three years (and a median of 40%), compared to a 5.2% return for the S&P/ASX All
Ordinaries Index. Only eight of the 38 had suffered negative returns in that time. Figure 5 sets
out the ten CEOs identified in that study with the highest dividend entitlement as a
percentage of their executive remuneration.
Figure 5: Top 10 CEOs whose annual dividend entitlement most exceeded FY12 remuneration
Source: Capital IQ, Investorfirst
For CEOs to hold enough equity to earn strong dividend yields, there is a strong likelihood
that they were involved in the establishment or earlier growth stages of the business.
And for that reason, small and mid caps are the companies where such CEOs are most likely
to be found. The average market capitalisation of the 38 companies identified was $865m at
the time and the median was $222m.

Nearly five years later we have checked how the stocks in Figure 6 have performed. The
results, set out in Figure 6, are consistent with our “Alignment of Interest” thesis:
● Only one of the ten stocks has declined in value (ASL, a mining services contractor)
● The average total return over the period of the ten (not factoring in any reinvestment of
dividends) was 70% and the median was 77%
● This compares with a 58% total return from the S&P/ASX 100 Accumulation Index;
and a 22% total return from the S&P/ASX Small Ordinaries Accumulation Index
● The Accumulation indices assume dividends are reinvested so this comparison
understates the amount by which the 10 companies have outperformed.
● Six of the 10 outperformed the S&P/ASX 100.
● Nine of the 10 outperformed the S&P/ASX Small Ordinaries Index.
Figure 6: Revisiting those Top 10 in 2017 (returns from October 2012 to July 2017)
Source: Iress, Equitable Investors

Constructive & Activist Investment

The 2017 Top 100 Hedge Funds as ranked by Barron’s Penta was of note to Equitable
Investors because of the characteristics of the top ranking fund. Based on annualised
three-year returns, Alantra Asset Management's EQMC Europe Development Capital Fund
was the top performer. This fund has averaged more than 20% a year, net of fees, since its
inception in 2010. On an annualized three-year basis to the end of 2016, it gained over 26%.
Alantra’s EQMC Europe Development Capital Fund relied on good stock-picking but also
“friendly active investing” to nudge core holdings to improve corporate governance, operations,
capital allocation, and strategic decisions. When the dialogue was not welcomed, the
manager kept its position small or moved on.
While that is just an anecdote, we know from academic studies that shareholders with
enough influence to hold company’s to account can enhance value.
Research from Harvard, published in June 2015, concluded that an initial spike in a share
price following activist intervention was “reflecting correctly the intervention’s long-term
consequences”. Similarly, a research report in 2009 compared targets of activism with control
groups matched for size and industry and found, as set out in Figure 7, that even after the first
30 days of an initial 13D Filing (the US equivalent of a substantial shareholding notice in
Australia), the excess returns for the rest of the 12 month period were significant.
Figure 7: Abnormal stock return from Activist Target Firms between 30 days & 12 months
after initial 13D filing
Source: Entrepreneurial Shareholder Activism: Hedge Funds and Other Private Investors (Klein & Zur)
Given the greater ease with which an investor can purchase an influential interest in a smaller
company, this is yet another potential source of excess returns that would be biased to
smaller companies (but by no means excludes opportunity among larger listings).

Liquidity Premium
Small firms, particularly micro caps, are in general going to be less liquid than their larger
peers. This is perhaps most visible when one reviews the bid/ask spreads of shares spread
across the market capitalisation spectrum.
Figure 8: Arbitrary Bid/Ask spread examples for ASX listings (sourced in August 2017)
Market Cap
($m)
Last price
($)
Bid ($) Ask ($) Mid-point
($)
Spread ($) Spread /
Mid-point
144,550 84.54 84.48 84.59 84.535 0.11 0.13%
2,250 8.64 8.62 8.64 8.63 0.02 0.23%
498 1.04 1.025 1.04 1.0325 0.015 1.45%
78 0.53 0.53 0.55 0.54 0.02 3.7%
12 0.016 0.015 0.017 0.016 0.002 12.5%
Source: Thomson Reuters, Equitable Investors
The implication of this liquidity issue is that excess returns in smaller companies may be
considered to be, at least in part, compensation for the liquidity risk. Patient investors can
benefit from illiquidity.
Valuation - Price Matters
Logic dictates that the return you make on an investment is dictated by the price you paid.
Numerous research papers have confirmed the importance of price, typically focusing on low
price-to-book or price-to-earnings multiples relative to high multiples. There is also evidence
that “value” (lower multiples) performs more strongly as a factor for smaller companies.
Our analysis of Australian value-based factor returns, based on academic Kenneth French’s
widely-used data, shows that between 1975 and 2016, stocks ranked in the lowest 30% of
the market on their price-to-earnings (P/E) ratios exceeded returns of the most expensive
30% of the market in 53.4% of all months. This doesn’t sound like much but:
● In months where low P/E stocks outperformed, they did so by an average of 3.8%.
● In months where expensive P/E stocks outperformed, they did so by the lesser
average amount of 3.5%.
The compounding impact of the outperformance of value both in regularity and size has proven
to be huge. Even over a more recent time span - since 1990 as demonstrated in Figure 8 -
lower P/E stocks have outperformed in six out of 10 years and on average their annual excess
return over higher P/E stocks has been just over 5% a year.

Figure 9: Relative performance of Low PE and High PE Australian stocks since 1990
Source: Kenneth French, Equitable Investors
Internationally, investment researcher Brandes Institute found the cheapest 10% of small caps
globally delivered an annualised return nearly 7% higher than the most expensive 10% of
small caps, examining the period from June 1980 to June 2012. This compares to a 5.3%
margin between the cheapest and most expensive deciles of large caps. Stocks were
classified into value or glamour deciles based on their multiples of book value, earnings and
cash flow. Brandes found that Australia was one of nine markets where a value premium was
evident (along with Canada, France, Germany, Italy, Japan, Singapore, UK and USA).
Figure 10: Annualised five year returns and standard deviations by value decile (global study)
Source: Brandes Institute

Correlation
An important characteristic of micro caps in particular is that they are less inclined to move
with the broader market (as measured by free-float weighted indices like the S&P/ASX 200).
Figure 11, below, shows the correlation of indices proxying for broad market capitalisation
classes. Correlation of one means they move perfectly in sync and the lower the number is
the less commonality in their movements.
Figure 11: Correlation between Australian market cap segments (monthly)

Micro Small Mid Large
Indices used:
MSCI Aus Micro Cap
S&P/ASX Small Ordinaries
S&P/ASX Mid-Cap
S&P/ASX 100
Micro 1.000 0.653 0.398 0.407
Small 0.653 1.000 0.868 0.824
Mid 0.398 0.868 1.000 0.888
Large 0.407 0.824 0.888 1.000
The correlation characteristics of micro-cap stocks suggest that adding these stocks to a
typical balanced portfolio may improve risk-adjusted returns.
As an example of applying this lower-correlation benefit, Equitable Investors has considered
the impact of blending the MSCI Australian Micro Cap Index with large and mid-cap indices,
like the S&P/ASX 100 and the S&P/ASX Mid Cap Index. Using daily data running back to
May 2014, it can be seen that:
● Both Micro Caps and Large Cap indices generated low annual growth: 2.6% & 1.2%
● Mid Caps outperformed in this period, returning just under 10% pa
● Annualised standard deviation was 15% for Micro, 14% for Mid & 12% for Large
● So the ratio of return per unit of risk was: 0.2 for Micro, 0.7 for Mid & 0.1 for Large
Using this data and recalculating the portfolio standard deviation and returns at varying
weightings, we built a sensitivity graph allowing us to identify what would have been the
optimal blend of Micro and Large indices, the results of which are depicted in Figure 12.
There was a clear benefit from blending these size-based classifications, with the maximum
return per unit of risk achieved at an approximate 60/40 blend of Micro / Large.
Even if we focused instead on Micro blended with Mid for this period, in which Mid excelled,
the highest return / risk ratio would have been achieved using 15% Micro, as Figure 13
illustrates.

Figure 12: Impact on Return/Risk ratio if varying Micro Cap weightings blended with Large Cap
(using annualised data from May 2014 to August 2017)

Figure 13: Impact on Return/Risk ratio if varying Micro Cap weightings blended with Micro Cap
(using annualised data from May 2014 to August 2017)
Of course, very different results may have occurred using different historical periods.
But this analysis highlights that a portfolio allocation to smaller stocks can be beneficial for
investors who favour larger stocks, supporting an investment strategy such as “Core and
Satellite”, whereby an investor might complement a core holding that tracks a major large cap
index with a satellite investment in smaller stocks.

Conclusion
While investment success will ultimately rely on good judgement and good fortune, Equitable
Investors believe there is clear evidence that judgement can be informed by logically deduced
and quantitatively demonstrated factors and characteristics. Rather than focus on specific,
rigid classifications (such as “micro cap” or “value”) to define our investment universe,
Equitable Investors leverages this knowledge to inform the investment process and maximise
the likelihood of investment success.
We believe investors will benefit from this knowledge when applying it to their own investment
portfolios, as Equitable Investors does in its own process.
Figure 14: Equitable Investors Investment Process
Our process for the Equitable Investors Dragonfly Fund, as set out in Figure 14, capitalises on
the knowledge shared in this document in the following ways:
➔ Current Investment Universe | The Small Cap Effect - Our default position is to screen
for companies with market caps less than $5 billion.
➔ Negative Screens | “Control Your Junk”, Valuation - We screen out companies that
don’t meet basic quality criteria or have valuations stretched to extremes.

➔ Positive Screening | Valuation - Price Matters - We rank the remaining stocks based
on valuation metrics in order to determine which to prioritise in our research
➔ Active Research | The Neglected Firm Effect, Alignment of Interest, Constructive
Investment & Activism - Our active research, which also yields additional investment
candidates for screening, ultimately informs our views on valuation and risk and takes
into account these factors; active research also forms part of our constructive
engagement with key people driving existing investments in our portfolio
➔ Valuation | Valuation - Price Matters - We set our informed view on value and risk as
the outcomes of our Active Research
➔ Portfolio Construction | Information Assimilation, Liquidity, Valuation - Price Matters,
Constructive & Activist Investment - Having assessed value and risk, the remaining
information for decision making is price; we consider whether we may have a better
understanding of new information than is expressed in the market price; we consider
opportunities presented by illiquidity or liquidity; we consider management willingness
to pursue value-maximising strategies.
➔ Portfolio Optimisation | Correlation - We are conscious of minimising correlation, a
task made easier by the natural bias of the process to smaller stocks and our
bottom-up-approach, which means our process isn’t overly biased to specific
industries.
Obtain your own advice
This document does not take into account the particular investment objectives, financial
situation and needs of potential investors and the contents of this document are not to be
construed as investment, accounting, financial, legal or tax advice. Before making a decision
to invest in the Fund the recipient should obtain professional advice.

Seeking Advantage (Sep 2017)

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