Value investing is probably at least a hundred years old: it was already a long-established practice by the time Benjamin Graham and David Dodd published the first edition of Security Analysis in 1934. And one of its central tenets is patience. One buys a stock that appears cheap and one waits patiently for it to rise in price to a level that approximates its intrinsic value. This could take years, and often does.
Let’s say you bought all the stocks in the S&P 500 and held them for four years. When would be the optimal time to sell each one? When their price is the highest, of course. The chart below plots the number of bars that it takes S&P 500 stocks to reach their four-year peak. (I obtained this data, and the data in the rest of the article, from Portfolio123 by screening every two years since 1999 for stocks that were in the S&P 500 or microcap universe four years earlier, so it therefore does not include stocks that no longer existed after four years). The bar on the right shows the most recent five months; that’s when 38% of the stocks reached their highest points. And no doubt most of those went (or will go) still higher.
Now the chart below repeats the same experiment with microcaps. The result is markedly different. 25% of the microcaps reached their peaks within five months of purchase, and another 25% reached their peaks within the last five months. Not only that, but the four-year survivorship rate for microcaps is only 74%—compared to 90% for the S&P 500—due to a higher level of mergers, acquisitions, and bankruptcies; if one were to take that into account, the percentage that reach their peaks four years after purchase would be markedly smaller.
And what kinds of peaks are they? Well, the average peak among that 25% that achieved their high within five months was an increase of 52% over the purchase price. Of course, one would have to be superhuman to sell at exactly the right point, but considering that peak was achieved an average of 43 bars (two months) after purchase, your superhuman stock seller would achieve a CAGR of over 1,000%. By contrast, the average high among the microcaps that lasted close to four years was an increase of 212% over the purchase price, which makes for a CAGR of 34%. There’s a huge survivorship issue here too, which I wasn’t able to take into account—a lot more microcaps are going to survive for 43 bars than for four years.
All this suggests that the optimal holding period for microcaps is significantly shorter than that for large caps—in fact, it’s only about two or three months.
Microcap investors have a host of advantages over other investors, which I’ve detailed here and Jim O’Shaughnessy has detailed here. But to reap the maximum profit from those advantages, it’s best not to play the buy-and-hold game. Over the last two years I’ve doubled my money by investing in microcaps. I would not have done half as well if I hadn’t sold most of my holdings within a few months. Patience is indeed essential to successful value investing, but with microcaps impatience may be more profitable.
My ten largest holdings right now: VHI, AVDL, ALSK, CVV, CRNT, ELMD, SMMT, GSL, CTG, KMDA.
CAGR since 1/1/2016: 47%.
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