Brad Pitt And The Smaller Companies Effect

Brad Pitt is currently starring in Moneyball, the film of Michael Lewis' book of the same name. This tells the story of how the Oakland Athletics (A's) baseball team outperformed most of their richer competitors during the late 1990s and early 2000s, after discovering that certain skills and tactics were undervalued by the market.

Private investors have a similar advantage over the institutions that dominate the stock market. That's because of the "Smaller Companies Effect", the tendency of smaller companies' shares, as a group, to outperform the bigger companies over the longer term.

Whilst the Smaller Companies Effect is fairly well known, certain factors prevent the institutions from taking advantage of it. Private investors can thus capitalise as a result and beat the big guys, just like the A's did.

Playing ball

I won't go into much detail about the techniques used by the A's, as we recently published an article about baseball statistics and measuring investment performance.

Basically what happened was that amateur statisticians discovered that professional baseball teams were mispricing skills and tactics. That's because they still viewed the game using 19th century statistical methods, which gave an incomplete picture of how it was actually played. The A's were the first professional team to take note of this.

One of the most undervalued skills was the ability to get onto first base without hitting the ball (a "walk"). In contrast, some highly prized skills, such as being able to "steal" a base, turned out to be somewhat overpriced. Similar discrepancies were found in pitching (bowling for us cricket fans) skills and tactics.

So the A's manager Billy Beane hired players with these undervalued skills, many of whom had been passed over by other teams, and changed the team's tactics. The English equivalent of what happened next would be if a small football club like Wigan Athletic qualified for the UEFA Champions League and r! emained a contender for several seasons.

Private investors can follow the example of the A's by looking at smaller companies, many of whom are undervalued. But they need patience as the smaller companies effect develops over the longer term.

Why does this happen?

Several factors combine to produce the smaller companies' effect; information uncertainty, higher transaction costs, the illiquid nature of the market in many smaller companies' shares, and investors wanting higher returns as smaller companies are riskier investments.

Information uncertainty exists because larger companies are more closely followed by the market, and are thus better understood. So the market is less likely to fully appreciate the value of a smaller company, which can create an undervaluation.

Dealing can be costly

Transaction costs are the bane of investors as they eat into their returns. One of the largest of these is the bid-offer spread, the difference between the buying and selling price of a share. The spreads on smaller company shares are usually much greater than those for the larger companies.

Some institutions will routinely trade 100% of the value of their portfolio over periods of less than 18 months, so they favour the larger companies with their tighter spreads as this cuts their dealing costs. Private investors can afford to take the longer term view.

For example, as I write this Britain's biggest supermarket chain Tesco (LSE: TSCO.L - news) is valued by the market at 32 billion and its shares are 404.5p to buy and 404p to sell, a difference of just 0.12%. In contrast the spread on the 78 million property company Town Centre Securities is 151p to buy and 143p to sell; a massive 5.6%.

You might be able to cut your costs by dealing at better prices than those quoted, known as inside the spread, but ! there's no guarantee of that.

Less easy to trade

Most institutions are concerned about liquidity, the ability to get in and out of a company's shares without significantly affecting the price. If you're a pension fund that's looking to sell 10 million worth of shares of BP , this can be done relatively easily as the market for BP shares is huge.

But the fund needs some good fortune if it wants to sell 10 million worth of shares in a company that the market values at just 100 million. They may even find that no-one wants to buy that many shares, or they'll have to accept a big discount to the current price, if they want a quick sale.

Another reason is that smaller companies are riskier investments than larger companies is because they don't have the same financial muscle, and their profits are often highly dependent upon just one or two products. So investors want smaller company shares to offer higher returns to compensate for the extra risk that they are taking on.

The private investor's advantage

As a private investor you don't have the same concerns and constraints that are placed upon most financial institutions. You should generally be able to buy and sell shares in smaller companies without moving the price, and can afford to take a longer term view because you're not under pressure to meet quarterly performance targets.

Whilst the A's advantage wore off after a few years, because the other teams in the league worked out what they were doing and started to use the same methods, the smaller companies' effect has been public knowledge for over 50 years, yet it hasn't vanished because of the conditions that the institutions operate under.

Come on you Spurs!

Finally, football fans might be interested to know that Billy Beane is a fan of Tottenham Hotspur (Berlin: TTN.BE - news) and ha! s been a dvising the club for several years. Is it just a coincidence, even with Harry Redknapp taking over as manager in 2008, that Spurs are one of the most improved clubs in the last few seasons?