I have a puzzle to pose to those of you who have slightly more training than the common investor.
I found this graph at a Fundrise page for an innovation venture fund.
I am contending that the data on this graph effectively disproves EMT. Can you explain why I am making this claim?
If it is not evident, I can give you a hint. It is: What if you consider the Stocks, Bonds, Bills, and Inflation results versus this graph?
If the answer is still not at hand, then let me give you a second clue: consider the material presented on this Fundrise page about private equity.
The EMT Problem
The first important clue to the puzzle is that the small cap ROR shown above is below that of mid cap and large cap equities. We should generally expect that riskier investments have higher rates of return, but somehow that has not been the case from 1984 to 2015. The volatility is in the right direction, but not ROR. Mid cap equities have both higher return and higher volatility, as we would expect.
A parallel problem is that non-U.S. equities have much higher volatility, but lower ROR than any of the U.S. equity categories.
Another important clue: Buyout funds have higher ROR and lower volatility than any of the equity classes.
A Thesis about Why Small Caps have Under-performed
An important point made in the Fundrise page is that tech companies have been remaining private longer. Some of them emerge from their IPOs as mid caps or large caps. Private capital is capturing more of the gains of early stage companies. That leads us to the conclusion:
Private equity is skimming off the best small cap companies from the public markets.
But if the market were efficient, then their attempts to "skim" would for naught, as any attempt to buy the "best" small cap stocks would be countered by higher small cap prices in the public markets prior to acquisition. The way to get a reduction of the small cap ROR from the SBBI results (which include 1926 to 1984 as well as the more recent years) is for private equity to have a "stock picker's edge" in selecting small cap stocks.
This edge can also be seen in the high ROR for buyout funds.
Not all small caps were bought by private equity funds. Some were bought by other public companies, including public companies that had an edge in buying their small cap competitors. The FAANGM have bought and eaten hundreds of small cap companies over the last 20 years, and it wouldn't surprise anyone if the people running those companies had an inside edge on which public (or non-public) small cap companies were worth buying. Or you could think of the FAANGM as being venture or mutual funds in themselves. Then the excess return one would typically associate with a small cap instead would show up as enhanced return of the tech large cap stocks. This certainly feels plausible, as the FAANGM cluster has done inordinately well over the past 10 to 12 years.
Entanglements with SBBI
This presents problems for those who rely (such as we did in our advice on outperforming professional investors) on SBBI results to prospect for future returns. If the future small cap candidate pool will have been cherry-picked by private equity, then what does that say about the future of SBBI and small cap index funds?
What could account for this outcome? SBBI only dates back to the early 1970s. As the SBBI results became more widely believed (perhaps in the mid-1980s?), private equity became an increasingly large force in the overall marketplace for equity. We might think that there were forces tending to make the market efficient, and this is reflected in how private equity has been scooping superior small caps from the market. If there had not been a small cap premium, there wouldn't be opportunities for capturing the excess that fed private equity.
One piece is missing: Many would argue that a strong component of private equity performance is the additional management expertise, aligned with capital, that can be brought to a deal. Then a small cap equity returning 12% in the public market could in theory return perhaps 13% or 14% or more under alternate ownership. This in turn means that public small cap stocks that would "naturally" return less than 12% could also be bought out and it would be more efficient for private equity to buy them and manage them than if they were publicly owned. An 11% stock with a 2% gain due to private ownership then becomes a 13% return; better than public ROR, and better than if the private acquirer were to only hold a partial stake in the company as publicly owned. This in turn would then explain the gap in the graph above. Only below average small caps would remain in the market after private equity had cherry-picked the better performers.
Other Theories About Small Business Formation
If business formation is substandard to past eras, then the supply of small business could be less than the long term historical norms. I have not made a systematic study of this, but this chart seems to show that U.S. business formation has been declining.
If we assume that the efficient market theory applies to privately owned small businesses all the way down to sole proprietorships and companies employing less than 15 people, then this graph is not something that can be overcome by "boosting" small businesses via Small Business Development Centers, government programs, special grants to disadvantaged entrepreneurs, and similar interventions. Special programs that favor women-owned, minority-owned, and Native American-owned businesses in Federal Government contracting are rampant and have been in place for a long time, so there are more opportunities for entrepreneurs, not fewer.
It could also be that the costs of being a public company are higher than before. Increased regulation would also cause this to happen. If so, then the founder of a private company would tend to hold onto it longer before selling shares to the public, and therefore could potentially collect more of the superior returns available inherently in the business while it is growing rapidly. This also matches what Fundrise's second chart shows:
(Considering the current moral climate of the country, I feel it worth mentioning that having the founder "skim" from his own company by delaying when he takes his company public is completely fair. It is ridiculous to suggest otherwise; no owner "owes" it to others to take a company public sooner. Before 2020 I would not have written those sentences; now I feel that such needs to be said because there are many people who will automatically assume that founders have a duty to work harder than everyone else, take the risks on themselves, and then deliver the resulting profits to the public for free.)
If there is a shortage of small caps, then the value generated by a good new small business will be captured faster than it was before. So, from the perspective of an investor who is also willing to be an active investor, this era calls for angel investments and personal entrepreneurship as active and increasing percentages of the total investment portfolio. It is certainly the case that a great business will reward the owner far beyond the SBBI averages. If you can maintain a 20% to 30% ROE, then your money is better placed on the liabilities side of the general ledger of a small business you run yourself, because that's your return, 20% to 30%.
In some circles it might be common to write poetic lamentations about how people have lost their fire, their passion for new ventures. I scarcely think that is relevant; it is just emoting. If we believe America's SBDC and their 8/2/2022 blog entry, business formation is not suffering from any lack of enthusiasm:
"2021 broke a record year for entrepreneurship with five million new businesses started."
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