Market Watch : Small-Stock Indexers Still Waiting for Ship to Come In
Investing with Rex Sinquefield and David Booth is a form of existentialism: A stock exists, therefore they own it.
Their strategy also has been a form of masochism for seven years running, because the stocks that they buy are those of small companies--which have painfully lagged the broad market since 1984.
Sinquefield and Booth’s $5-billion investment firm, Santa Monica-based Dimensional Fund Advisors, is the nation’s largest index investor in small stocks.
They do no original research, no projections of earnings trends or other fundamentals. They don’t care what the companies produce. Shares of 3,200 small U.S. companies and 2,800 small foreign companies sit in their portfolio--just because.
Index investing, which rose to prominence in the 1980s, is the antithesis of active stock picking. Instead of trying to outperform the market by picking the best stocks, indexers seek to match the market by owning all of the stocks that make up key market indexes or subgroups.
If it sounds like joining ‘em because you can’t beat ‘em, that’s exactly what it is. Index investors believe in an efficient market. Therefore, it’s impossible for a money manager to beat the market over the long term, indexers argue. Better just buy the whole market.
When the witch in “The Wizard of Oz” wrote “Surrender Dorothy!” in the sky over the Emerald City, it might as well have been these guys taunting the money managers who try to make a living picking stocks. Says Booth: “Nobody is out pushing the index concept like we do. We actually believe this stuff.”
Investors associate index investing mostly with the big stocks that make up the Standard & Poor’s 500 index. Booth and Sinquefield, both schooled at the University of Chicago and both true believers in that institution’s free-market philosophies, founded DFA in 1981 to extend indexing to small stocks.
It was, Booth admits, “a salesman’s dream” of an idea. Big investors, he says, “agreed they should have it (an indexed small-stock portfolio), but they didn’t have it” because no one offered it. By the end of 1981, DFA had $234 million under management.
In the beginning, DFA bought only the smallest 20% of the stocks on the New York Stock Exchange, measured by market capitalization (stock price times number of shares outstanding). In 1984, the firm began adding over-the-counter stocks. In 1985, with business booming, Booth and Sinquefield moved DFA to Santa Monica from Chicago, for the quality of life. Their Ocean Avenue offices now are home to 40 staffers. A London office has a staff of 14.
Behind DFA’s success in attracting money is a basic tenet long respected on Wall Street: the idea that small-company stocks outperform big stocks over the long term. No one can say exactly why the so-called small-stock effect occurs. The simplest theory is that, because small companies by nature grow faster than big companies, their investors are better rewarded. For whatever reason, it works:
* In the 50-year period ended in 1989, the average annualized return of small stocks was 14.1%, versus 11.8% for the blue-chip stocks in the S&P; 500, DFA calculates.
* Over the past 20 years, small stocks also did better, though not by as much: 11.8% versus 11.6% for the S&P.;
But in the 1980s, the trend reversed itself. In the five years ended in 1989, the S&P; sharply outperformed small-stock indexes, 20.4% to 12.4%, annualized. Every year since 1984, investors have kept telling themselves that it’s only a matter of time before small stocks return to the fore. They’re still waiting.
What’s wrong? Sinquefield and Booth have no concrete answer. “But on some level, it has to be earnings-related,” Sinquefield says. One argument is that big companies operated more efficiently than small companies in the 1980s because of the big firms’ drastic restructurings. Takeover mania also helped big stocks.
A few years of under-performance, however, can’t erase the long-term proof of small stocks’ better returns, DFA says. “The logic is unassailable,” Booth says. Yet, he admits, “people are frustrated because we’ve done so poorly.”
Even so, most of DFA’s major clients--names like Blue Cross of California, the City of Seattle and British Aerospace--have stayed put. Why? “Well, we think small-cap stocks will turn around someday ,” says Georganne Perkins, an analyst in the Stanford University treasurer’s office. Stanford, which has been with DFA since 1984, has $32 million invested with it.
A strong argument for DFA’s approach is that foreign small stocks continued to outperform their big-stock rivals in the late ‘80s, even though U.S. small stocks lagged. DFA began investing overseas in 1986, and its expertise with those small stocks has attracted U.S. investors.
Perhaps equally important is the fact that DFA’s clients know that, despite the U.S. portfolio’s dismal showing, DFA knows the tricks of managing a small-stock universe.
That’s no small feat. By their nature, small stocks are difficult to buy and sell because there are few shares outstanding. DFA owns stakes of 5% or more in about 500 of the 3,200 U.S. companies in its portfolio. A big investor who fails to move nimbly and quietly can send a small stock’s price way up when trying to buy and way down when trying to sell--defeating the paramount goal of getting the most efficient price.
DFA has a “buy” list of small stocks that it wants to add to its already huge universe. Rather than throw money at the stocks, it takes a patient approach, Booth says--cultivating relationships with brokers, spreading buy orders among 40 or 50 brokers nationwide and waiting for “motivated” sellers to surface. Transactions involve plenty of haggling, and DFA engages in undercover work to avoid transactions in which would-be sellers know something it doesn’t--such as an upcoming event that might crush the stock.
“They’ve shown they’re very adept at trading,” says DeWitt Bowman, chief investment officer for the California Public Employees Retirement System, which has $600 million invested with DFA.
The same kinds of patient strategies apply when DFA sells. And the firm sells only when a small stock outgrows the “small” definition, which now ranges from $140 million to $400 million in market capitalization, depending on the DFA portfolio.
That’s one of the ironies of DFA’s index approach: A company doesn’t exit DFA’s portfolio by going bankrupt, but by becoming so successful that its stock hits the big leagues. Do well, and you’re out.
That may make it sound as if DFA is investing backwards. And partly because their approach isn’t easy to swallow at all times, DFA doesn’t seek out small investors. The minimum investment it accepts is $50,000, and individual clients can invest with DFA only through certain financial planners.
While they wait for small stocks to return to their historical performance, Sinquefield and Booth have another concern to contemplate: Whether index investing might be a trend whose time has passed, after booming in the ‘80s.
Could the ‘90s belong to the stock picker rather than the market buyer? You’ll never get Sinquefield and Booth to believe that anyone can be smarter than the market over the long term.
Asks Sinquefield rhetorically: “What is it that’s changed in the 1990s that suggests markets won’t work anymore?” If you need further proof of market logic, he says, just ask the Soviet Union’s communists--who have decided to junk the alternative after 73 years of failed results.
KEEPING THE FAITH IN SMALL STOCKS -- BUT FOR HOW LONG?
Measured over 50 years, small stocks have produced far better returns than big stocks--in the United States and abroad. But the past 10 years have seen U.S. small stocks lag badly. Their fans are betting that will change in the 1990s. The performance record (boldfaced numbers show best results in each time period):
Total returns, annualized (except 1990)
1990 5 years 10 years 20 years Stock universe (to 8-31) 1989 (‘85-’89) (‘80-’89) (‘70-’89) U.S. small stocks* -15.5% 15.9% 12.4% 14.6% 11.8% U.S. big stocks (S&P; 500) -6.5% 31.5% 20.4% 17.5% 11.6% International small stocks -7.4% 29.3% 45.9% 28.8% 26.1% International big stocks -14.7% 14.7% 36.9% 25.4% 19.7%
50 years Stock universe (‘40-’89) U.S. small stocks* 14.1% U.S. big stocks (S&P; 500) 11.8% International small stocks NA International big stocks NA
* companies in the lower 50% of NYSE stocks, by size, plus similar OTC and Amex stocks
