A Small Cap-Based Disproof of the Efficient Market Theory (EMT)

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.

We also have anecdotes like the "flying cars" comment by Peter Thiel that expresses this sentiment. Government regulation has increased over the last 30+ years as well. The economy has shifted from rewarding physical work to intellectual work, starting in the early 1970s, which raises both the entrance requirements for building the average new business and the stakes involved.

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."

Where to Put Your Mind

It is a never-ending quandary in investing that you can never know enough to create an optimal investment portfolio. If you broaden your search and knowledge, then your expertise in a particular sector will be thin compared to those who specialize in that sector. If you specialize in a sector, then you may outperform others in that sector while completely missing out on other sectors that outperform yours. With enough hubris and in-borne talent you might attempt to know a lot about everything, but even if you succeed, by the time you learn it the knowledge will be obsolete or you will have allowed too much of your life to pass by to enjoy the fruits of your information advantage. 

It gets worse. With respect to knowledge about a particular sector or stock, understanding your position in a skill hierarchy is costly. Even when you act within your circle of competence, you must decide either to act with your current level of superior knowledge, or invest more time in refining it further, to beat the competition. Among specialists with which you compete some may have greater talent than you, but in order to know when you are at the top of the game you would need to invest time in learning how much the other experts know and how much they are investing in sharpening their skills. Such an effort would then compete with the time you have to invest in sharpening your skills.

When understanding the broader landscape, the more you search, the more time expended. You can attempt to locate the best performing sector, but at the start there is no guarantee that you will find it within an appropriate level of effort, or that the differentials among sectors will be worth the investment in cataloging their relative performance. Even if you locate an outperforming sector, you must then engage in extracting value from that knowledge, which may involve understanding that sector in at least some degree of detail. You might make the assumption that indexing across the sector would be sufficient, but in order to be sure that the assumption was correct, you would need to expend further effort understanding your selected sector.

Supposing that you were lucky or informed so as to have good breadth of knowledge of sector performance and depth within a chosen sector, you would still have the problem of evaluating the degree to which your knowledge would decay over time. That would control whether the advantage gained from the time invested would actually pay off in greater rates of return for long enough to pay back your time investment.

Systematic Methods

Those in quantitative professions are likely to answer these doubts with a systematic approach. The answer, at least to start, might be to survey, index, and gather numeric data on potential investments. This is certainly preferable to having no information, and in my personal experience, quantitative objective data is far superior to hunches and qualitative, subjective judgment. Still, as described above, there are limits to how much quantitative methods will advance your cause, and it can be costly. 

Perhaps the worst quantitative problem was a quip I heard many years ago that I'll loosely paraphrase: "The trouble with quantitative investing is that it finds the biggest flaw in your data and puts all of your money there." This was in the context of automated quantitative investing, which "quants" do.

When I say "quantitative" (vs. "quant") I mean any sort of numeric analysis and comparison method, starting with analyzing the balance sheet, income statement, and cash flow statements, and including fundamental ratios (PE, P/S, margins, ROE), revenue and earnings histories, and more tactical data like same store sales, customer account retention, employee turnover, and market share. It also means comparison of a large number of stocks side-by-side in some fashion, valuation, and comparison to historical values. Though quantitative methods have a tendency to consume lots of resources before they produce results, the large majority of such data is nearly impossible for the human brain to grasp at once. Such data figuratively makes the difference between being blind and seeing trends.

Notice that although I am not including any form of technical analysis in my definition of "quantitative", some aspects nevertheless qualify as objective, numeric, and potentially automated, so as to eliminate bias. In this sense, although I will claim that I make little to no use of technical price and volume analysis, it at least has some advantage over purely subjective methods because of its numeric nature.

Focusing Methods: Theory

Where do you put your attention? Do you even have control of it? This is a deep question of psychology and philosophy, and will lead you to considerations of free will if you carry it too far. If you've read to this point it is probably fair to say at least that you are attracted to the idea of improving investment results by paying attention to something, including the subject of focus.

The focus problem is another quandary, an aspect of the "optimal information gathering" problem described above. For the sake of discussion, I will confine this analysis to what to focus on once you have already allocated attention to the problem of inspecting your investments. There isn't much to be gained in looking at why you don't have time for investments, or can't even start thinking about them. You likely aren't reading this post if you fall into those categories.

To begin, although some prominent people have declared that focus was helpful to their success, it's not clear that a concentrated focus is a critical activity. Too much concentration might lead one to overlook obvious dangers or obvious gains. Too little might lead to inaction. What is the optimal level? What gets the job done? Aside from homespun bromides, I'm not aware of any scientific research, success stories, or compelling common sense that declares that "this level of focus is the right one," whatever that might be. Some clearly non-optimal levels of focus are none and too much. 

Nevertheless, focus strongly affects your investments. You can't buy something you aren't aware of, and if you are too aware of your own holdings, you won't have the adverse information and perspective you need to sell them when it is objectively required. There are many, many opportunities for regret, some leading to "analysis paralysis" in which you become so aware of the many things you don't know, and compelled to find out before acting, that the information search prohibits you from taking any action until it is too late.

Though I've come nowhere close to "proving" that there is no optimal focusing method, it seems that this line of investigation is showing that there might not be anything close to an "optimal" focusing method, so instead we turn to smaller measures. We shall be inspired by folklore and common sense here.

Practical Focusing Methods

This section will use a brainstormed list of ideas for maintaining focus, obtaining or re-obtaining focus, or changing focus. Since these are practical and not theoretical methods, the proof of their performance will be in whether they work for the reader.

• making a checklist once, for today, at the beginning of the day, and going through it
• using a canned checklist that contains items that historically have been useful to review, or which at least we think might be useful to review
• looking around to see what catches your attention right now (requires that looking around be slightly more than just doing nothing)
• asking people near you what's new
• looking at an internet-based website that has a feed based on (something)
• meditating
• reflecting on what is more important, perhaps as amplified by a Franklin-Covey planner or similar time-tracking system, and using critical long term goals that can be fed through near term actions
• reading psychology papers, such as Kahneman and Tversky's psychology papers on non-rational thinking, or the behavioral economics literature, and reflecting on how those principles impact whatever it is that you are supposed to be doing today
• just doing it

Is this list satisfying? I would not be surprised if it leaves you cold. Perhaps you are thinking that I didn't really do my homework today, that this list really ought to be different, better, more complete, or more informed by research. If so, please comment. 

Using The Force to Jump Outside the Box

This article originally started as the introduction to the BDC survey I published earlier this week. It grew beyond that mission and so became its own article. The focus section was started on twice, resisted being written at least once, and perhaps changed shape overnight after the first attempt. At this moment, as I write this, my own impression is that the topic of focus is probably very misunderstood among practitioners. Nearly every industry business standard or development standard (CMM, CMMI, ISO, Kanban, DevOps, Six Sigma, etc.) involves some of the steps in the list above, with very strong emphasis on doing something, a business practice, over and over again in repeatable ways. What's missing is any sort of approach when you have a problem that is not repeatable.

The first bit of folklore to use to illustrate the problem is "the Force" in Star Wars. Is this a focus trick? It certainly seems to be. The Jedi advice is, roughly, do not plan or worry too much about the future, that rather than have your mind elsewhere, one should focus on being where they are.

"Always remember, your focus determines your reality." 

“Your eyes can deceive you. Don’t trust them.”

“Mind tricks don’t work on me.”

“Don't center on your anxieties, Obi-Wan. Keep your concentration here and now, where it belongs.”

Many years ago I spent a day playing a business game called Gold of the Desert Kings. Each team's task was to travel (virtually, via a game board with markers and other game accessories) across the desert, mine gold, and bring it back. Although at first you were given part of the goal of the game, you were not told much about anything else. Rules, options, potential events, and other details were omitted at the beginning. Turns were timed, with hard deadlines. Lots of information was unknown, but you were allowed to ask some types of questions. 

After it was over, during the debriefing, we were told a story. Who was the highest scoring team ever and how did they achieve it? The answer, was that the team asked early in the game what was possible, what was the previous highest score? Having obtained that answer, they could then work backwards and deduce other unknown aspects of the game. The lesson seems to have been: Find out what is possible before deciding what to do. 

The meta lesson: Jump outside the box before establishing a focus. 

This lesson too will be unsatisfying and inapplicable to some circumstances. If we have no free will the question of where to put focus and this answer are meaningless. But perhaps we do have free will, and making an effort to consider the problem is part of the art of obtaining "optimal focus", if there is such a thing. In the process of journeying briefly through the problem of where to put your attention, perhaps we have improved our chances at putting it in places of most utility.