Is the Size Premium in Stocks Still Valid?
One of the first so-called “anomalies” hypothesized by financial researchers was the size premium, which posits that small-capitalization equities tend to outperform large-capitalization equities over time. First identified by researcher Rolf Banz in 1981, the size premium was subsequently incorporated as part of the 1992 Fama/French Three-Factor Model for describing portfolio returns.
However, researchers are becoming less confident that the size premium—at least, as it has traditionally been understood—is valid for predicting returns on equity investments. For one thing, small cap stocks have underperformed the broader markets since July 1926, providing by far the worst performance among the four asset subclasses (large growth, large value, small growth, small value). Additionally, the much higher volatility associated with small growth stocks as compared to large growth or large value stocks calls into question the actual “quality” of portfolio growth; some research indicates that the greatly increased risk from volatility may not justify the marginally higher returns. In addition, penny stocks, stocks in bankruptcy, and IPOs, all of which are included in the small-growth category, have contributed to small-cap underperformance.
It’s worth noting that small growth stocks make up about a third of the capitalization of small stocks overall, which handicaps their overall return. Without that component of the small cap universe, the size premium would be visible and persistent.
Some research suggests that “junk” stocks, very small, often distressed, always illiquid securities, can be weeded out to increase the quality profile of the sector, and that small quality stocks outperform large quality stocks. In other words, the challenges to the size premium can possibly be mitigated by controlling for quality. When researchers weeded out “junk securities” according to their definition, they found a robust size premium that is present in all time periods. They also found that eliminating high-beta (higher volatility) stocks had basically the same impact.
Later research may suggest that the size premium doesn’t work alone, but operates predictably when combined with factors like momentum, value, and high quality. Further, researchers observe that the factors all may have a bigger impact in small stocks than large stocks. This hypothesis suggests that the size effect can be realized by building portfolios that combine it with other factors.
Other research measuring historical relative valuations based on book-to-price, earnings-to-price and sales-to price suggests that small stocks are historically relatively cheap compared with large capitalization companies. When that has been the case in the past, small caps have outperformed the market overall by 7.20% a year over the subsequent five years.
Ultimately, much of the research literature confirms the wisdom of creating diversified portfolios that incorporate multiple, unique sources of risk and return, and having the discipline to adhere to a well-thought-out plan. This is the general guideline we advise for most clients. While focusing on one sector may yield favorable results for a period, it is impossible to predict the continuing performance of any single sector—much less any particular stock—with reliable accuracy. For that reason, we continue to believe that broad diversification and discipline will yield the best results for investors.
If you would like to learn more about the factors we consider most important to long-term success in investing, click here to read our white paper, “The Informed Investor.” And if we can answer specific questions, we would love to hear from you.