This paper examines the effectiveness of a profitability screen on improving return and reducing volatility and drawdown for Australian small-cap stocks.
- On average, 28% of companies in the S&P/ASX Small Ordinaries were unprofitable over the period studied, in contrast to 9% in the S&P/ASX 50. Small-cap companies with positive earnings per share (EPS) historically outperformed the unprofitable companies on both absolute and risk-adjusted bases.
- The S&P/ASX Small Ordinaries Select is designed to track profitable small-cap companies in Australia. The index’s addition of a profitability screen helped it to outperform its benchmark by 1.2% per year from Sept. 20, 2002, to Dec. 31, 2019.
- Sector allocation and stock selection effects both contributed to the excess return of the S&P/ASX Small Ordinaries Select, with the sector allocation effect explaining a larger part of it.
- The S&P/ASX Small Ordinaries Select had higher dividend yield and active profitability factor exposures compared with the S&P/ASX Small Ordinaries.
SMALL-CAP BEHAVIOR IN AUSTRALIA
In 1992, the capital asset pricing model (CAPM) evolved into the Fama & French three-factor model to include size and value as risk factors in addition to market risk, with the aim to help better explain a portfolio’s risk/return characteristics. Inclusion of small-cap companies offers diversification and potential for higher returns.
Exhibit 2 shows the return correlation of various common Australian investment classes. Australian small caps had return correlations of 0.83 and 0.91 with large and mid caps, respectively. Among the three size categories in Australian equities, small caps had the lowest correlation with Australian bonds, Australian REITs, and international equities.