One of the major deficiencies of equity management is that the basic risk classifications clearly do not validly reflect risk. The basic classifications are large-, medium, and small-capitalization stocks. This is based on empirical data that demonstrates that small-capitalization stocks exhibit greater return variability than large-cap stocks. Ergo, it is impossible to resist the conclusion that an investment in small-cap companies entails more risk. But what is true in the aggregate might have little to do with reality at the individual stock level (the level that matters for an active manager). For instance, El Paso Electric is a small cap company, with a low beta, in a low-risk business. Tesla is a large-cap company with a stock market capitalization of $52 billion. Honda also has a market cap of $52 billion. Tesla sold 84,000 vehicles in 2016; Honda sold 5 million vehicles. Tesla loses money; Honda is profitable. Not even the most passionate advocate of the proposition that small cap stocks are riskier than large cap stocks would dare assert that an investment in an equity like El Paso Electric entails more risk than an investment in Tesla.

Download: June 2017 Spin-Off Compendium