Leveraged Small Value Equities

Abstract

The size premium and value premium are well documented in academic studies. We contribute to this literature by finding that leverage – as defined by long term debt divided by enterprise value – enhances the average returns of a small-value investment strategy. At the company level, our results indicate that there is a positive interaction between leverage and value. We test a variety of quality and technical factors to develop a theory of what works in leveraged small-value equity investing. We develop a ranking system for creating annual portfolios of leveraged small-value stocks in the United States. This ranking system prioritizes smaller, cheaper and more leveraged stocks that are already paying down debt and exhibit improving asset turnover. Annual portfolios of the top 25 stocks in this ranking system have a 25.1% average annual return between 1965 and 2013. At a standard deviation of 39.4%, the Sharpe Ratio of these annual portfolio returns is 0.51. These portfolios have a CAPM alpha of 9.6% and a CAPM beta of 1.66. The average risk-adjusted return of these portfolios is 13.1% per year after controlling for the 3 Fama-French factors, momentum, and liquidity. In addition to providing a novel investment strategy, we believe that our findings have implications for the leveraged buyout industry – which follows an analogous investment approach in the private markets – as well as for public market value investors who have traditionally eschewed leverage.