Small Stocks, Nasdaq, and Other Market Pitfalls

. POWERFUL idea can move mountains. With the pubhcation of Malleus Maleficarum-The Witches Hammer, in 1487, the idea swept through Europe that Christianity was thickly beset with the minions of Satan. It was the duty of the faithful to root them out and destroy them, before they destroyed the world. The ensuing panic lasted 200 years and saw tens of thousands tortured, strangled, burned alive.

The belief was so dominant that any allegation of witchly powers was accepted without hesitation. Their bodies were said to be made of "light air" that could pass through the densest substance with ease. They multiplied quickly, and their ranks were swelled by demons and the souls of the wicked. Johannes Weir, a physician of Cleves, and an authority on witchcraft, asserted in the 1560s that there were exactly 7,405,926 demons of the air, divided neatly into 72 battalions, each led by a prince or a captain.

The air was filled with them, and the careless could inhale thousands in a single yawn. They would then merrily wreak havoc on the inner anatomy, causing intense pain. In great multitudes they created tornadoes and whirlwinds on land, violent storms at sea, and delighted in destroying both nature and the works of man. (Its surprising the producers of B-grade horror flicks searching for new material dont make more use of the idea.)

Wizards and witches met weekly for their Friday night "Sabbath" with Satan. Attendance was compulsory; failure to show up resulted in the miscreants being lashed by demons with rods made of serpents or scorpions.

King James I of England fretted openly about what to do with this infestation of evil that threatened to take over all the kingdoms of Europe. Crisis inevitably breeds opportunity, and this was no exception. Witch

Small Stocks, Nasdaq, and Other Market Pitfalls 317

hunting became a lucrative profession. The leaders in the field had their own state-of-the-art detection devices. One was the Icnowledge that only a witch or a sorcerer could float on water when their hands and feet were bound and their bodies wrapped in a sheet or blanket. Hundreds of thousands of people were put to this test. If they floated they were burned at the stake; if they drowned, they were innocent. Also accepted as indisputable proof of witchcraft was that no witch could recite the Lords Prayer or scriptures from the Bible correctly. If someone on trial for witchcraft mispronounced or missed a word in front of a massed group of hostile accusers, which under this pressure was a strong possibility, her fate was sealed.

Widely accepted beliefs often appear silly, sometimes horrifying in hindsight. Unfortunately they occur just as often today. We will examine several in this chapter. First take the popular and cosdy myth that small stocks have a long record of outperforming their larger-sized siblings. At first glance, the logic is simple and compelling: small companies, often in rapidly expanding industries, are cheaper and are growing much faster than larger ones. That makes their stocks a better bet than old-fashioned, lumbering giants of industry.

Statistics brought forth in the early eighties supposedly supported this contention. So popular has the notion become that hundreds of billions of dollars have been invested by millions of investors in pint-size companies. Again, as in the case of witches and sorcerers, the belief was unfounded. With barely a ripple or a trace, investors money sank beneath the waves. It is important for you to be aware of the pitfalls in this area.

The Small Company Blues

The beginnings were highly principled. Two young Ph.D. candidates at the University of Chicago, Rolf Banz and Marc Reinganum, were engaged in the lofty cause of defending the efficient market hypothesis in the late 1970s when it was initially challenged by the findings of the low P/E strategy. The two wrote their Ph.D. theses on the validity of the small-cap effect. Some of the leading figures of efficient markets, including Eugene Fama, Roger Ibbotson, and Myron Scholes, sat on their dissertation committees.

Heres where the myth got its first academic blessing. Rolf Banz "proved" that small stocks outperformed large companies over time. Mark Reinganum concluded that there was no low P/E effect; rather it was a small-cap effect. Without the small stock effect, low P/E stocks did not beat the market.

Banz studied the performance of companies listed on the New York Stock Exchange between 1926 and 1979. He placed stocks in five equal groups by market value for five-year periods over the length of the study. For the entire 54 years the average rate of retum on small companies was 11.6%, compared to 8.8% for large stocks.

The results were published in the Joumal of Financial Economics in March 1981, but the preliminary findings were given to Fortune almost a year earlier, at the time a strong believer in efficient markets. It then did a feature on the work.

As Fortune summed it up,

[T]he small-stock phenomenon has indirectly refuted the most serious challenge yet to the efficient-market theory. A number of researchers have demonstrated that portfolios of stocks with low price-eamings ratios have regularly outperformed the market averages. That finding, trumpeted by David Dreman in his book Contrarian Investment Strategy, is wholly inconsistent with an efficient market. It tums out, however, that low P/E stocks appear to offer superior retums only because small stocks have lower P/Es, on average, than large ones. [Emphasis mine.]

Why did smaller companies do better? Banz didnt know. "There is no theoretical foundation for such an effect," he said. "We do not even know whether the factor is size itself or whether size is just a proxy for one or more trae but unknown factors correlated with size." Although admittedly unsure of what these findings signified, Drs. Banz and Reinganum used them to dismiss the low P/E su-ategy. To quote Banz again in Pensions and Investment Age, a periodical widely read by pension fund and money managers: "We still do not know why the [size] effect exists ... however, no other thesis, such as ... Dremans Contrarian Investment Strategy, explain[s] the effect."

My curiosity more than a little whetted by the Fortune article and Banzs statements about the failure of low P/E, I undertook my own research on the subject. What did Banz actually discover? My findings indicated that some ofhis work looked right at first glance. But look out! The reasons are far different from what Professor Banz and the efficient market researchers might think, and once again illustrate the danger of using statistics blindly.

The Banz findings did not pertain to small caps at all, since he used as a sample all the companies on the New York Stock Exchange (NYSE). Back in the late 1920s when his study began, and through the next several decades, even more than today, the NYSE was Americas