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Investing in U.S. equities, from Richard A. Ferri’s All About Asset Allocation

This is from Chapter 6 of All About Asset Allocation: The Easy Way to Get Started, by Richard A. Ferri, CFA.

A History of U.S. Equity Returns

Over the long term, an investment in U.S. equities has delivered exceptionally good returns. As America prospered during the twentieth century, established companies grew and new companies in new industries were established. U.S. industry enjoyed steady earnings growth, even through two major world wars. As a result, U.S. companies paid reliable dividends, stocks increased in value, and shareholders profited.

From 1950 to 2004, the broad market for U.S. stocks returned 12.1 percent annually. That handily beat the 6.2 percent return on five-year Treasury notes and the 3.9 percent level of inflation. Table 6-1 is an after-inflation rate of return over different periods of time. The inflation-adjusted return is also known as the real return because it is the amount of purchasing power the investment created.

Table 6-1: Real U.S. Stock and Bond Returns
1950–20041968–19822000–2004Historic Average Over Inflation
U.S. stocks8.2%0.2%-4.9%5% to 7%
U.S. five-year T-note2.3%0.3%5.1%1% to 2%

Source: Standard & Poor’s; St. Louis Federal Reserve.

Real returns reinforce the fact that inflation is an invisible tax on all investments. The portion of return that is related to inflation cannot be counted as investment gain. When creating an asset allocation for your portfolio, you should always consider the expected real return of the investments you are considering.

It is not always easy to make a real return in the U.S. stock market. There have been several periods of time between 1950 and 2004 when U.S. equities did not perform well. For 15 years, from 1968 to 1982, the inflation-adjusted return of U.S. equities was barely above the rate of inflation. From 2000 to 2004, U.S. stocks lost 4.9 percent annually after accounting for inflation. If U.S. stocks average a real return of 5 percent from 2005 to 2010, over the entire 10-year period from 2000 to 2010, stock returns will return slightly greater than zero percent after inflation, and negative after income taxes.

Investors must expect periods of time when equities do not make money after inflation. That is the nature of investment risk. However, patience is a virtue. In the long run, equities have outpaced inflation by a wide margin, and they are expected to be one of the investments with the best real return in the future.

U.S. Equity Market Structure

When a company sells stock to the public for the very first time, it is distributed through a tightly controlled initial public offering (IPO). Investment bankers are hired to bring the company public and promote the shares. Investors who get the new shares tend to be large institutions that do significant business with the investment banker and friends of the officers of the company that is coming public. Individual investors who do relatively little business with large Wall Street firms and have no influence with management generally do not get access to the hottest IPOs. This is not the fairest system of distribution, but that is the way it works.

Once a stock is issued under the IPO process, it begins trading on the secondary market. Which stock exchange carries a new company depends on the company’s financial history and the value of the company. There are about 8,000 U.S. stock that trade actively in the U.S. equity market; however, only about half meet the criteria to trade on a major exchange. Companies must meet certain listing requirements to be eligible to trade on the New York Stock Exchange (NYSE), the American Stock Exchange (AMEX), or the National Association of Securities Dealers Automatic Quote System (Nasdaq). Companies that do not qualify for listing on the NYSE, AMEX, or Nasdaq are called bulletin board stocks or pink sheet companies.

Table 6-2: Approximate Number of Stocks on Each Exchange
Stocks Sorted By ExchangeNumber of CompaniesPercent of Total Market Value
New York Stock Exchange1,66580%
American Stock Exchange375<1%
Bulletin board stocks3,500+<1%

Source: Wilshire Associates.

Table 6-2 is a breakdown of where stocks trade in the United States. The table includes only individual U.S. common equities. It does not include listed bonds, preferred stocks, exchange-traded mutual funds, or foreign stocks listed on U.S. exchanges.

You can buy bulletin board stocks through a broker that has access to that dealer market. Years ago, dealers who were members of the National Quotation Bureau (NQB) would publish weekly bid and ask prices on bulletin board stocks on long sheets of pink paper, thus the name pink sheets. The list would be distributed to all brokerage firms. Brokers now refer to electronic pink sheets if one of their clients wants to buy or sell a nonlisted security.

The Broad Stock Market

Wilshire Associates is a privately owned investment firm with headquarters in Santa Monica, California. Since its founding in 1972, the company has developed a wide variety of U.S. indexes, one of which is the Dow Jones Wilshire 5000 Composite Index. The Wilshire 5000, as it is commonly known, was the first U.S. equity index to capture the return of the entire market of listed U.S. stocks. Those are the companies that are listed on the NYSE, AMEX, and Nasdaq. Bulletin board stocks are not included in Wilshire indexes.

When originally introduced in 1974, the Wilshire 5000 Index held 5,000 stocks, thus the name. Today, the number of stocks in the index depends on the number of stocks trading on the major U.S. stock markets, which equals about 5050.

The major criteria for inclusion in the Dow Jones Wilshire 5000 Composite Index are as follows:

  • The company must be headquartered in the United States. Nondomiciled U.S. stocks and foreign issues (ADRs) are excluded.

  • The stock must trade in the United States on the New York Stock Exchange, the American Stock Exchange, or Nasdaq.

  • The stock must be the primary equity issue for the company.

  • Common stocks, REITs, and limited partnerships are included.

  • Bulletin board issues are excluded.

The Dow Jones Wilshire 5000 Composite is the most complete broad market index; however, there are several other broad market indexes. They include the MSCI US Broad Market Index (~3,800 stocks), Russell 3000 (~3,000 stocks), Dow Jones Total Market Index (~1,625 stocks), Morningstar Total Market (~2,000+ stocks), and Standard & Poor’s 1500 (~1,500 stocks). There are several low-cost index funds available that attempt to match the return of these broad market indexes. A partial list of those funds is available at the end of this chapter.

Size and Style Opportunities

An investment in a total U.S. stock market fund is a solid foundation on which to base a stock allocation. From there, you can analyze various sectors of the U.S. stock market to possibly find an opportunity to add greater diversification through selectively overweighting one or more sectors. To do sector analysis, investors need a system for segmenting the market so that the sectors do not overlap.

Morningstar, Inc., in Chicago is a widely respected mutual fund and stock research company. The company has developed a comprehensive strategy for categorizing stocks that includes 97 percent of the U.S. equity market. The system is called the Morningstar Style Box. The nine-box grid divides stocks into three distinct size factors and three valuation factors. See Figure 6-1 for an illustration of the style box methodology. For a complete description of Morningstar’s methodology, refer to the Rulebook at http://indexes.Morningstar.com/.

Figure 6-1: Morningstar Style Box Methodology with Micro-Cap Added
Ultra SmallMicro Cap

One limitation of the Morningstar Style Box methodology is that it covers only about 2,000 of the largest stocks, thus overlooking more than 3,000 very small micro-cap issues that trade on U.S. exchanges. Accordingly, Figure 6-1 adds an extra micro-cap stock portion to the bottom of the Morningstar box to increase the coverage to 99% of the U.S. equity market.

The Morningstar Style Classification System

The Morningstar size classification system categorizes companies according to their free float market value. The free float market value is defined as a company’s outstanding market value less private block ownership. In other words, the free float market value of Microsoft stock does not include the value of the shares owned by Bill Gates. Free float is a common method of index construction that is widely becoming the standard for index providers.

The three Morningstar size classifications plus an extra micro-cap size cover 99 percent of the stock on the U.S. market. The four categories are:

  • Large cap = largest 70 percent of investable market cap
  • Mid cap = next 20 percent of investable market cap (70th to 90th percentile)
  • Small cap = next 7 percent of investable market cap (90th to 97th percentile)
  • Micro cap = remaining 2 percent of investable market cap (97th to 99th percentile)

As a reminder, the micro-cap portion is not a Morningstar style. I took the liberty of adding the box to show where that size category would fit if it were included in the Morningstar classification system. The micro-cap box completes the classification system so that it includes all stocks listed on the NYSE, AMEX, and Nasdaq. The only stocks not included are bulletin board stocks.

The Morningstar Style Classification System

All index providers classify companies by style as well as size. Different index providers determine value and growth using different methodologies. Some providers divide their indexes between growth and value. Morningstar divide theirs into three categories depending on fundamental characteristics. These categories are value, core, and growth. Morningstar categorizes companies using a multifactor model that consists of five variables. Table 6-3 highlights those five factors. The most influential factors in the equation are the stock’s price compared to its past earnings and price compared to projected earnings.

Table 6-3: Variables and Weights Used by Morningstar in Style Analysis
Value FactorsGrowth Factors
  • Price/projected earnings (50%)
  • Price/book (12.5%)
  • Price/sales (12.5%)
  • Price/cash flow (12.5%)
  • Dividend yield (12.5%)
  • Long-term projected earnings growth (50%)
  • Historical earnings growth (12.5%)
  • Sales growth (12.5%)
  • Cash flow growth (12.5%)
  • Book value growth (12.5%)

Morningstar first calculates a company’s value score, then its growth score, and finally its overall style score by subtracting the value score from the growth score. If the result is strongly positive, the company is classified as growth If the result is strongly negative, the company is classified as value. If the value score minus the growth score is not sufficiently different from 0, the stock is classified as core.

Breakpoints for value, growth, and core are set so that over a three-year rolling period, each style represents one-third of the investable universe within each capitalization class. That keeps a nearly equal number of stocks in each style box. Morningstar reconstitutes each index twice annually (adding or removing stocks). It also rebalances the indexes quarterly (adjusting constituent weights).

Based on this methodology, the Wilshire 5000 Composite Index falls roughly into the boxes illustrated in Figure 6-2. Each box contains the number of stocks in that particular box and the percentage of the index represented by the box.

Figure 6-2: Average Number of Stocks in the Morningstar Style Boxes
Large Cap
Mid Cap
Small Cap

The large-cap row holds 225 stocks, which is only 5 percent of the stocks in the Wilshire 5000 Composite Index. Yet those 225 stocks represent 70 percent of the free float market value of the entire listed U.S. stock market. It is interesting to note that it takes more than 3,000 micro-cap stocks to make up 3 percent of the listed market.

Performance by Size

The weighted-average market value of the stocks in an index has a profound effect on that index’s long-term performance. In the late 1970s, two academic researchers, Rolf Banz and Marc Reinganum, independently found that micro-cap stocks had a long-term return close to 5 percent per year higher than large-cap stocks. That fact was not a great revelation, since smaller stocks had much higher volatility than large stocks and were expected to return more. However, using new financial models of risk and return developed by William Sharpe, researchers Banz and Reinganum found that micro-cap stocks had higher-than-expected returns even after accounting for the extra volatility. Something else was going on in the micro-cap marketplace that was not being picked up by the return volatility numbers.

It was also interesting to Banz and Reinganum that sometimes the prices of micro-cap stocks moved in the opposite direction from large-cap stocks. That meant that the return on micro-cap stocks did not always correlate with the returns on the rest of the market. As a result, there may be a diversification benefit to owning micro-cap stocks in greater weight than the 3 percent position inherent in a total stock market index fund.

Table 6-3 offers excellent insight into the difference in return between the broad market and micro-cap stocks. The Russell 3000 Index is composed of the largest 3,000 stocks traded in the United States. The micro-cap index in Table 6-4 is derived by the Center for Research in Security Prices (CRSP). The CRSP Stock File Indices contain historical market summary data on all stocks traded no the NYSE, AMEX, and Nasdaq back to 1926.

Table 6-4: Comparing Micro-Cap Stocks to the Broad Market
Russell 3000 IndexCRSP Micro Cap IndexCRSP Micro Cap Return minus the Russell 3000

Notice the large differences in return between the CRSP Micro Cap Index and the Russell 3000 during 1998, 2001, and 2003. These differences are surprising considering that both indexes hold thousands of publicly traded U.S. companies. Generally, academics believe that in a broadly diversified portfolio, individual company risk is diversified away, leaving only market risk. Therefore, a random portfolio of 3,000 stocks diversified across several industries is expected to return very close to the same performance as another portfolio of 3,000 stocks diversified in the same manner. Clearly, that is not the case when one portfolio is made up of only micro-cap stocks. Micro-cap indexes have a unique risk factor above and beyond indexes of larger stocks that cannot be diversified away by adding more micro-cap stocks.

Figure 6-3 reflects the 36-month rolling correlation between the CRSP Total U.S. Market return, CRSP mid-cap stocks, and CRSP micro-cap stocks. The CRSP Total U.S. Market returns are almost exactly the same as those for the Dow Jones Wilshire 5000 Index, only the data go back further. The CRSP Mid-Cap Index is highly correlated with the broad market. Consequently, a separate portfolio of mid-cap stocks has not been a good diversifier for investors who own a total stock market index fund. Micro caps are a different story. At times there is a high positive correlation between micro caps and the total stock market, and at other times the correlation is lower. The varying correlation signals diversification potential.

A portfolio that has an overweighting in micro-cap stocks acts differently from a total stock market portfolio. Figure 6-4 illustrates the theoretical diversification benefit that was achieved by adding 10 percent increments of CRSP micro-cap stocks to a total stock market index fund.

Had it been possible, over the 30-year period from 1975 to 2004, a portfolio of 80 percent in a total stock market index fund and 20 percent in a micro-cap index fund would have increased U.S. returns by 1.1 percent with a small increase in risk. However, the returns in Figure 6-4 are theoretical because there were no total market index funds or micro-cap index funds in 1975. That is not the case today. You can now purchase a low-cost no-load total stock market index fund and a micro-cap index fund.

The more than 3,000 micro-cap stocks that trade actively on U.S. exchanges count for only 3 percent of the value of the entire listed market. Accordingly, the performance of micro-cap stocks does not have a large impact on the performance of the broad market. Overweighting micro-cap stocks in a portfolio as a separate U.S. stock category has had diversification benefits in the past and may add diversification benefits in the future.

Finding a Micro Cap Fund is Difficult

Now the bad news: It is very difficult to find a low-cost broadly diversified micro-cap fund that is still open to the public. Most micro-cap index funds are closed to new investors or are available only through a paid investment advisor. Sometimes a closed fund will reopen to the public for a short period of time. When that occurs, you have to be ready to invest. That means monitoring certain funds for potential opening dates.

There are micro-cap funds that are open to all investors all the time, but be careful in your selection. Some of these funds have a high sales commission, others have exorbitant management fees, and still others invest only a portion in micro-cap stocks and the rest in small- and mid-cap stocks.

If a brand new fund is open, make sure the average market weight of the companies in the fund is less than $300 million and that it will be widely diversified, with at least 500 companies. Also ensure that the total expense is below 1 percent and that there is no commission to buy or sell shares.

–Richard A. Ferri, CFA, All About Asset Allocation: the Easy Way to Get Started (2006), pp. 84-95

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