I agree. When I talk about strong past 10-yr performance of the
companies I select, I'm talking first about their ability to earn a
profit (increasing profits), then I look at their cash flows (to check
that the profits are effectively there and not just on paper) and
finally the debt/equity ratio (only stocks with decreasing D/E are
selected). These are the most important fundamentals that come from the
income statement, cash flows and balance sheets of these companies.

Then it comes the critical factor: valuation. Given their past
performance, I make a (very) conservative assumption on future earnings
growth. If market values for every company are well-below future
discounted earnings, I buy the stock. As a reference, my small and
micro cap value portfolio had a weighted average earnings growth of
19.62% during the last 10-yr period (well above the market average),
and I'm assuming expected growth of 5.1 percent per year in the future.
This is about 80 percent of the historical earnings growth recorded by
the market as a whole, which has been 6.1 percent since 1950. My
assumption is even more conservative if we believe that micro and small
cap stocks with strong performance in the past usually outperform the
earnings growth rate of the market as a whole.


Tad Borek wrote:
- quote -

jose.bailen[at]gmail.com wrote:
- quote -


Jose, it sounds like you're creating what is in effect an
active-management method based on the Fama-French findings. If microcap
value is the part of the market with the highest expected returns, why
not cherry-pick within microcap value based on some methodology?

Which is fine, and makes sense -- but of course it depends entirely on
whether the methodology you use is likely to filter out stocks that are
going to outperform the basket of the hundreds that meet the criteria of
"microcap value." And it departs from the F-F conclusion which would be
to buy the basket of stocks, because of its risk characteristics, while
assuming that the market efficiently prices the individual issues within
the asset class.

"Strong 10-year performance" might actually be a poor criteria. It could
identify the stocks you should have bought 10 years ago, rather than the
ones you should buy today. I might look for the worst 10-year
performers, alongside some other criteria...my belief is that the
outperformance of value stocks, as an asset class, relies in good part
on the "return to grace" of companies that are currently doing poorly.
Of course within that is some garbage (risk) which is why it makes sense
to diversify broadly.

-Tad

By the way, DFA microcap portfolio is hardly a microcap value
portfolio, but a broad cross-section of microcap stocks. This is
important, since the overperformance comes from small and micro VALUE
stocks, not from small/micro growth stocks, which actually have the
lowest average rate of return of all categories of stocks (divided by
size and style). In fact, the 10-yr average rate of return of DFA
microcap is 12.8 percent, substantially lower than the 21.13 percent
yield of the representative microcap value portfolio during the last 10
years (see
http://www.moneychimp.com/articles/i...micro_deep.htm , based
on Fama and French data).



jose.bailen[at]gmail.com wrote:
- quote -


======================================= MODERATOR'S COMMENT:
Please trim the post to which you are responding. "Trim" means that except for a FEW lines to add context, the previous post is deleted.

If you select microcap value stocks randomly, I agree with you 100
percent: you need a lot of more stock holdings than just 28. In fact,
only 44 percent of value stocks have positive returns in the 2-yr
period after portfolio formation. However, if you select your stocks
based on a record of strong performance -10-yr performance- then you
don't need thousands of stocks to obtain a good return for your
investment (see, for instance,
http://webuser.bus.umich.edu/Lundhol...ski%20value%22).

In fact, my methodology was to depart from the 331 microcaps included
in the Zacks index (Powershares' ETF PZI tracks this index), and
select only those stocks with the strongest performance record (as
measured by a record of increasing earnings, free cash flow and low
debt/equity ratio) AND at least 25 percent undervalued (as measured by
the intrinsic value calculated by CapitalIQ, a division of Standard and
Poors). Since I selected ONLY those value stocks with the best
performance and more undervalued, I think that my strategy does not
need 1000 stocks to yield good results.

You may wish to check the characteristics of my portfolio, included in
this newgroup to discuss small and micro cap value
stocks:http://groups.google.com/group/small...p-value?lnk=li
Overall, the average stock in my microcap value portfolio has a market
capitalization of $237 million, a P/B of 1.29, a P/E of 11.4, a ROE of
15.6 percent, and it is undervalued (based on the market consensus on
future profits) by about 46 percent. I don't think that DFA would beat
that.



Tad Borek wrote:
- quote -

jose.bailen[at]gmail.com wrote:
- quote -

One comment on this...there's a lot more "dispersion" with microcap
value stocks, meaning differences in returns among stocks meeting the
criteria defining the asset class. I don't recall the exact
quantification of this, but it's an issue with value stocks generally.
Your 28 might not be nearly enough to achieve the returns of the asset
class, because you're likely to miss the very big gainers that fuel
returns.

As an example DFA's microcap fund holds over 2,000 stocks, and the
small-value fund over 1,000. Compare this to say Large-cap US
stocks...the Dow 30 has very similar long-term returns to the S&P 500,
and their day to day changes are about 92% correlated. If you picked 28
random, large-cap stocks, your returns would likely be highly correlated
to the Dow or S&P 500. That's not necessarily true with the smaller issues.

-Tad

According to Fama and French, from the Graduate School of Business of
the U. of Chicago and the Tuck School of Business of Darmouth, the best

long-term inflation adjusted average rate of return portfolio is a
microcap value portfolio (average annual real rate of return of 13.95
percent between 1927 and 2005, see
http://www.moneychimp.com/articles/i...micro_deep.htm).
I've
been looking for months for a fund investing in these type of assets
(small capitalization and low price-to-book value), and the only one I
found was closed to new investors since 2004 (Frankin Microcap Value).
I've decided to create my own portfolio of microcap value stocks of 28
stocks, spread between different sectors -although the financial sector

and consumer goods are overrepresented, because they look undervalued;
and the energy, technology and health sectors are underrepresented,
because they appear overvalued-. I've used my Fidelity.com stock
screener to select only financially strong stocks -i.e., stocks with a
record of increasing EPS during the last 5-yr period, low
debt-to-equity and positive price-to-cash ratios, and (mostly) a
period of at least 10-yr in the market.
On average, my portfolio has a P/E ratio of 12.1, and a price-to-book
value ratio of 1.2. If you want to know the composition of my
portfolio, just let me know.