Fleas and Elephants

Thursday, Jun 06 2019 by

I first came to the thoughts in this post when I noticed that for the universe of stocks that I track, the median Quality Rank was about 63 rather than 50 as you would expect. So I decided to have a look at how the QVM ranks change with Market Cap, as my universe is limited to stocks with Market Caps over about £90m.

Jim Slater famously said that "elephants don't gallop" to describe the fact that share prices of large market cap stocks tend to move slowly. He later extended this by adding that "fleas can jump many times their own body height" to describe the behaviour of micro-cap share prices.

The implication is that small cap stocks and micro-cap stocks can provide much better returns than the blue chips. However this is a simplification of the true situation.

The distribution of Market Caps in the market: fleas, elephants and woolly mammoths

Slater defined an elephant as a stock with a market cap above about £5bn to £10bn and a flea as a stock with a market cap below about £5m to £10m.

These definitions correspond to the bottom 10% and top 5% of the UK stock market as you can see in the histogram. The elephants roughly correspond to the FTSE100.

This histogram has a log scale for the x-axis. Elephants are 1,000 to 10,000 times bigger than fleas.

The median market cap is about £100m. In other words, half of the companies have a market cap below £100m and half above £100m.

However because this is a log-normal distribution, if we ask about the balance of money across the market we get a different result.  

If we ask for the market cap where half of the total value of the market is above that value and half below that value, it is at about £28bn. To put it another way, the top twenty stocks account for half of the total value of the market and the remaining 1600+ stocks account for the other half.

So half the stock market's total capitalisation is not even all the elephants. You just need the twenty heaviest elephants - the "woolly mammoths" of the stock market absolutely dominate a weighted index.

The question to consider is whether fleas really are a better bet than elephants. So now let's look at the…

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10 Posts on this Thread show/hide all

Glorenfeld 6th Jun 1 of 10

Thanks Nick, I found this very interesting.

Taking your final point about stop-losses, I'm not sure I follow why this is the case. If one were trading the volatility (either instead of, or while investing in the underlying trend), then wouldn't a reasonable stop-loss make sense to reduce the risk that the volatility swings are against your last trade?

I don't try to trade volatility of any of my holdings, so this is an entirely academic question.

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Howard Adams 6th Jun 2 of 10

Hi Nick

Very informative posting, thank you.

I have been pondering volatility for a while now.

Your posting has prompted me to create a screener using BETA and Volatility % tests to incorporate into my screening procedures.

I will be intrigued to re-test my current holdings against these. I think I might be surprised to see where my current screening regime has led me with regard to the distribution of volatility across my holdings.

Many thanks for the inspiration.


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monions 6th Jun 3 of 10

Excellent article Nick. This echoes the feeling that I've had around small cpas for a while, your quantitative analysis has helped confirm my unstructured feeling.

I've used volatility as one of my 'litmus' tests when checking shares before buying. But I'd not noted the strong correlation with very small stocks. My threshold has always been around £50m, but your analysis suggests better returns could be seen by increasing that threshold. I'll take a look through the last 2 years worth of trading records and see how this looks.

Thanks for the insightful thoughts.

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Merlotman 6th Jun 4 of 10

Nick thanks for this - very interesting
As you say your analysis concludes that as a general rule as a buy and hold income investor you are best placed at the large cap space whilst those looking to make money trading stocks can gain most in the small cap space. . This further affirms the view that no one investing style is best it just depends what suits your personality and risk appetite.

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gpacker 6th Jun 5 of 10

Great article thanks.

I use a medium term NATR to filter out volatile stock, this generally presents large cap, but very often a small cap with good fundamentals pass the filter and have proven to be great selections.

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Nick Ray 7th Jun 6 of 10

In reply to post #481476

Taking your final point about stop-losses, I'm not sure I follow why this is the case. If one were trading the volatility (either instead of, or while investing in the underlying trend), then wouldn't a reasonable stop-loss make sense to reduce the risk that the volatility swings are against your last trade?

The problem with stop-losses on very high volatility stocks is that swings of +/- 20% or more are "normal". You just have to live with them.

Trading volatility actually works in the opposite way. You buy more when the price falls and top-slice when the price rises. It will fail very badly if the price keeps falling and never rises (enough).

But for certain kinds of microcaps (especially ones sitting on large cash piles and no debt which periodically ramp themselves shamelessly) it can work. However it is very risky.

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Glorenfeld 7th Jun 7 of 10

In reply to post #481726

Thanks Nick

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Graham Ford 7th Jun 8 of 10

Many thanks Nick. Another very interesting post.

I’m wondering how this actually translates into the increase in share price. In other words, for equal QVM ranks is there a difference in share price performance versus market capitalisation? I think (don’t have any good data) that over the longer term (several years) when it comes to funds the average increase in small cap funds is higher than the average increase in whole of market funds.

Perhaps the performance ‘history of profitability’ data on the ranks menu gives us that at least in part.

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Richard Goodwin 7th Jun 9 of 10

As always @Nick Ray your articles are amazeballs! And much appreciated

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mmarkkj777 7th Jun 10 of 10

A really great, well structured article Nick (as ever). Thanks.

Your results kind of mirror my overall investing methods. Quality large caps for buy and hold. Smaller caps/younger companies to trade.

My 3 best stocks by far this year have been Beyond Meat, Games Workshop and Future. Beyond Meat especially has been been very volatile since its IPO and i've ridden it bearback (no stop in place), but with heart in mouth at times. Risk management has been via position size.

Best large Cap has been McCormick $MKC.

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