Why Ordinary Folks Are Smarter Than Many PhDs

One of my college professors would often respond to students’ ideas by saying…

That sounds good if you say it fast enough.”

It’s a way of saying that the idea makes sense if you don’t stop to think about it. But if you give the idea a little bit of thought, you’ll see that it doesn’t work – at least not all the time.

It’s also how I react when academic quants talk about a big misconception in the market…

Eugene Fama is regarded as one of the most influential economists of our time. He has worked with countless others over the past six decades – including Kenneth French…

In the early 1990s, Fama and French highlighted an investment factor known as the “small-cap effect” in one of their studies. In short, their research on past stock-price behavior showed that small-cap stocks outperformed their large-cap counterparts over time.

But it’s misleading…

You see, small-cap stocks don’t always outperform. In fact, for much of the period since those studies roughly three decades ago, large caps have fared better. Even worse, the academics didn’t bother to understand why one group of stocks is stronger or weaker.

On the other hand, ordinary folks – who speak of “flight to quality” (moving to large caps) or “great upside opportunities” (small caps) – get it right more than the folks with PhDs. They understand that large- and small-cap stocks have inherently different reward-risk setups.

And that’s easy to see with today’s real-world data…

The following table breaks down the median stocks in each of the market-cap categories – ranging from “nano” at the low end to “mega” on the high end. Take a look…

First, look at a few metrics on the table – operating margin, interest coverage, and return on assets. These metrics all highlight the efficiency of scale…

It’s clear from the table that larger companies are more efficient in these categories.

With that in mind, it’s fair to associate large caps with the flight to quality. Larger companies are simply higher-quality companies using these metrics.

Small-cap investors, on the other hand, base their cases on the potential journey – from bad to good. That’s consistent with the huge volatility difference between the different market-cap sizes on the table.

Again, individual investors correctly see small caps as a source of great opportunity. (Just remember to understand and respect your tolerance for risk… Don’t risk more than you can afford.)

In sum, size isn’t an investment factor. Like most other metrics, it’s a starting point… It can help you differentiate between ordinary and potentially exceptional investments.

But don’t let the eggheads’ broad strokes fool you… Small caps don’t inherently equate to outperformance. And they face headwinds that large caps bypass because of their size.

On the flip side, large caps don’t offer the same potential volatility as small caps. That volatility cuts both ways… So it means the biggest potential gains are hiding in small caps.

It isn’t always a given, though, as the folks with the PhDs might lead you to believe. That’s why it’s critical to assess each potential investment on its own merit before you dive in.

In other words, stop to think about your idea. After all, everything sounds good if you say it fast enough.

Good investing,

Marc Gerstein

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