BLOG - Goodhart’s Law in action

Robert Davies, Fund Manager VT Maven Smart Dividend UK Fund

Charles Goodhart, economist and professor, formulated a law that says, roughly, when an economic indicator is identified to help monitor and manage the economy markets move to exploit it and render it ineffective. Similar logic applies to economic theories. Once an anomaly has been identified markets move to act on it and, ultimately, close it. It is possible to see this in action when applied to the theories of Fama and French that lie behind the Efficient Market Hypothesis.

In essence they say that it is hard to beat the market but that the extra risk found in small capitalisation stocks is usually rewarded by additional returns. This is one reason why there has been so much focus on small stocks in recent years with a number of funds specifically designed to channel money into this sector of the market.

Whether this action has been the sole, or even just the major cause, it seems this flow of money into a relatively small sector of the market has had a role in raising valuations. The aggregate data for the FTSE Small Cap Index, the 400 smallest companies listed on the London Stock Exchange, shows they have a dividend yield of 2.2% but didn’t, as a group, make any money last year so it was not possible to calculate an historic PE ratio.

Contrast that with the FTSE 100, the largest companies in the UK market, which have an average PE ratio of 16.4 and a yield of 3.8%. Lying between are the mid cap stocks of the FTSE 250 that have an average PE of 20.8 and a yield of 2.8%. Right now big caps are cheaper than medium and small cap companies.

Despite that discrepancy small stocks are still small and therefore, according to theory, still riskier than large companies which generally have more conservative balance sheets and easier access to capital. Over the last few years capital has been redirected to exploit the theoretically better returns from smaller and medium sized companies. So investors are now paying more for these stocks, not less, than their larger peers for the same return. On that basis mid and small caps now offer a lower risk adjusted return because the starting point is higher.

The important point here is that in the past the extra risk from mid and small caps was rewarded by higher returns. If returns are the same as large caps the trade-off no longer works. Moreover, it becomes even more unattractive when small and mid-caps have a premium valuation.

No one knows how events will turn out but history tells us that overpaying for any asset ultimately leads to lower returns. At the moment big caps are cheaper than small and mid-caps suggesting that Goodhart’s Law has over-ridden the theories of Fama and French. What happens next will be a true test of how efficient markets really are and, theoretically, it suggests that at some point big caps should start doing better than then their smaller rivals. And that gives investors every incentive to prove the academics wrong.

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