Abstract
The spotlight is generally on the FTSE / JSE Top 40 Index (J200) when investors look at the Johannesburg Stock Exchange (JSE). Small capitalisation stocks (small caps) are seen as risky, illiquid alternatives and, therefore, under-researched. However, it is these small cap stocks that are one of the drivers of economic growth by way of innovation. This study contributes to the prior findings of the presence (or the lack of) of the size effect on the JSE and further constructs a portfolio of ten small cap stocks based on nine fundamental ratios, during the 2006 to 2019 period. The ratios focused on the core operations and the financial health of the companies by identifying companies with optimal liquidity, profitability, and strength of the balance sheet. The aim of the study is to design an actively traded small cap portfolio using the nine fundamental ratios. The objective is to evaluate whether the portfolio can outperform the broader market, namely, the FTSE / JSE All-Share Index (J203) on a risk-adjusted basis. The performance of the portfolio will also be compared to the FTSE / JSE Top 40 Index (J200) and the FTSE / JSE Small Capitalisation Index (J202). Furthermore, the statistical significance of the nine fundamental ratios on the portfolio return will be evaluated. A decisive outperformance by the portfolio would have many implications, including debunking the Efficient Market Hypothesis (EMH), presence of size effects, and the exaggeration of liquidity risk when investing in small cap stocks. However, the results obtained were sub-optimal, in both absolute and relative terms. The portfolio failed to outperform the J203 over the period observed in this study. The small cap portfolio also took on more risk as evidenced by a larger standard deviation of returns. This is true for both growing and declining economic conditions. The portfolio achieved annualised returns of 4.40 per cent, with a standard deviation of 0.0408 and a beta of 0.4359. The J203 achieved annualised returns of 6.29 per cent, with a standard deviation of 0.0319 and a beta of 1. Therefore, the J203 had a higher Sharpe ratio (-0.2612) compared to the portfolio (-1.0064). There was no evidence on the presence of the size effect, nor were any abnormal returns detected. The investor would have been better off investing in an index fund that tracks the J203, than in a small cap portfolio.
Keywords: small capitalisation stocks, growth stocks, size effect, financial ratios, efficient market hypothesis, JSE