Since you brought up market caps, how are you currently categorizing large-, mid-, and small-caps from an investment perspective, and what kind of return potential do you see across all three categories?
Rather than the popular approach of segregating the market based on capitalization, a better differentiator can be seen through another approach where you segregate the market based on investment-grade securities versus junk-grade securities. We recently published a paper highlighting that over the past five years, junk-grade companies have significantly outperformed investment-grade companies on the equity side. To clarify, this is on the equity side, not the fixed-income side. We classify junk-grade equity companies using three distinct cutoff parameters, over the previous sixteen years of this study, while completely excluding banking, financial, insurance, and real estate companies from the entire list. First, we look at companies that have seen an average return on equity (ROE) lower than 5%, meaning they have not generated a good rate of return on their shareholder equity. Second, we look at companies with a poor debt-to-equity ratio that goes beyond 1.5 times. Third, we look at companies that have generated positive cash flows in less than 7 years out of the previous 10 years. When we measure the average performance of all such companies within a typical annual universe of top 1,000 companies by market cap, about 20%, or 200 companies, will fall into this junk-grade category.
