Smaller is not better for dividend investors

The small-firms effect is the theory that firms with a smaller capitalisation will outperform those firms with a larger market capitalisation. This effect was one of the three factors use in Eugene Fama and Kenneth French’s Three-Factor Model that was made in 1993.

To test this theory, we ran a backtest using the Bloomberg back-testing tool on the Singapore markets. In this test, we compared the performance of an equally-weighted portfolio of stocks against half the number of stocks with a different market capitalization.

Back-tests were done over the following:

• 10 years – Corresponding to the decade after the Great Recession. This is, generally speaking, a bullish period.
• 5 years – Corresponding approximately to the period where markets experienced the taper tantrum. This is a marginally bearish or sideways market.
• 3-years – Corresponding to the first three years of the Trump Presidency. This is, generally speaking, a bullish period.

Singapore Blue-chips

For Singapore blue-chips, we suspected that larger companies tend to do better because of its ability to dominate an entire market locally and power of Temasek as a sponsor. As such, we tested the strategy of holding 15 of the largest blue-chip counters against an equal-weighted portfolio of all 30 STI stocks. Our results are as follows in November 2019:

Returns	3 Years	5 Years	10 Years
30 Equal-weighted stocks	7.06%	0.77%	6.61%
15 largest market cap stocks	8.24%	2.9%	6.58%

Our intuition that smallest blue-chips stocks in Singapore do not out perform the largest ones held true. Larger blue-chip stocks did almost as well as the smaller stocks post-Great Recession. It outperformed during the taper tantrum era, like because local banks benefitted from rising interest rates. It also did better during the first 3 years of the Trump Presidency.

Singapore REITs

For S-REITs, we always believed that the larger REITs would underperform because we felt that older retirees are attracted to the larger REITs because it had more predictable cash flows and would be willing to settle for lower dividend yields. Recently, we noticed that after screening for smaller REITs, the performance has been dipping below the baseline to such a large extent that we can no longer resisting testing a strategy that hypothesizes that the larger REITs would have been better investments in the more recent years. Our results are as follows in November 2019:

Returns	3 Years	5 Years	10 Years
All S-REITs in equal weights	12.67%	8.25%	13.31%
20 REITs with the largest market cap	15.93%	9.44%	13.52%

The results shattered our expectations that the smaller and more ignored REITs would do better than the rest. The past 10 years was driven by a “flight to quality” towards REITs that are larger with better sponsors and quality management teams. One possible explanation is that larger REITs get a bigger chance to be included in major indices and stand to gain more liquidity from exchange-traded funds.

All Singapore stocks

This leaves the rest of the Singapore stock universe, a rich universe of 700+ stocks that can be purchased by anyone with a brokerage account. Before we started on our screening, we excluded China-domiciled counters, REITs and stocks below $50M in size. This eliminates the stocks that do not have sufficient liquidity in the markets. The new universe consisted of only 303 stocks.

This time around, we continued to actively hunt for the smaller counters to see if the small firms effect held for at least the larger universe of stocks that do not belong to the blue-chip or REITs universe.

Our results were as follows:

Returns	3 Years	5 Years	10 Years
All 303 stocks in equal weights	-0.90%	-4.39%	3.00%
Half of the 303 stocks with the lower market capitalization	1.99%	-3.45%	3.76%

From the results shown above, we can at least conclude that the small firms effect still held sway in the Singapore markets for a subset of liquid equity counters that are not REITs, China-domiciled or smaller than $50 million in size. The outperformance, however, was quite weak compared to many other value-based factors that were used in back-testing.

Conclusion

Academic theories should not be imported lock, stock and barrel into the Singapore Stock Market.

When investing in the more popular blue-chip and REIT counters, it would be dangerous to harbour the misconception that smaller firms outperform larger ones in Singapore. Instead, big is often better. Note that this is not the same as saying deep value strategies do not work. The evidence is clear that they still do. Just that they cannot be juxtaposed onto the popular blue-chip and REIT counters.

We have evidence that the small-firms effect holds sway when we broaden our screening criteria to cover a larger stock universe. Even then, using market capitalization as a criterion for picking stocks would not result in a strategy that would have led to substantial outperformance.

A careful study of what has worked in the past combined with the current state of the markets as well as an educated guess as to what comes next is necessary for investors to develop a more rigorous, time-tested approach for investing in the stock markets and extracting a superior performance with the added bonus of yearly dividend cashflows.

This is what is offered to students of the Early Retirement Masterclass. You can register for a seat here if you wish to learn our methods of approaching the markets with dividends in mind.