This is part two of a ten-part series on small-cap investing discussing the small-cap premium.
Throughout this series, I’m looking at both the benefits, and drawbacks of investing in small caps, considering all of the evidence available to us today for both sides of the debate.
When completed we are planning to turn the series into an e-book, which we hope will be a comprehensive guide to investing in small caps.
The series is a collaboration between ValueWalk and ValueWalk’s new small cap investing magazine Hidden Value Stocks.
Hidden Value Stocks is a quarterly publication which profiles two top-notch small-cap focused hedge funds in each issue. Within each issue, the managers discuss their investing process as well as to small-cap ideas each. To find out more, head over to www.hiddenvaluestocks.com.
The Small-Cap Investing Handbook Part Two: The Small-Cap Premium
Evidence of a small-cap premium first appeared in 1980 when a study titled “The Relationship Between Return And Market Value Of Common Stocks” was first published. Since publication, this study has formed the basis of a number of other academic studies that have tried to prove the existence of the small-cap premium.
Today investors are increasingly asking if this study remains relevant considering how the markets have developed since the late 70s. Not only has information on small caps become more widely disseminated but trading in these instruments is now easier than ever.
According to research conducted by Aswath Damodaran professor of corporate finance and valuation at the Stern School of Business at New York University, while a small-cap premium may have existed between 1928 and 1979 when the above study was published in 1980, it seems all of the excess small-cap returns evaporated.
Professor Ken French’s data library (on small-cap stocks) shows between 1926 and 1980, small-cap stocks earned on average of 7.18% more than the market each year. Immediately after 1980, the small-cap stock premium appears to have disappeared.
Between 1981 and 2014, small-cap stocks earned on average 0.18% less than the market each year. The dissemination of information certainly has something to do with this trend so do wider macroeconomic variables. For example, small caps outperformed large caps by more than 40% in 2002, after the dot-com bubble burst and by 60% in 1967. The best year on record for small-cap stocks was outperformance of 80% towards the end of the second war. The periods between these outlier events have been dominated by underperformance or moderate outperformance of 10% or less.
Still, even though Ken French’s data shows the small-cap premium is not a regular occurrence, it does demonstrate that it exists.
Further evidence of the small-cap premium can be found in a study titled “The Disappearing Size Effect” although this particular study finds that any small-cap premium disappears for companies with a market capitalization of over $5 million.
“During the period 1963–1981, we find an annualized return difference between small and large firms over 13% compared to a negative 2% return differential since 1982. Removal of the smallest firms (less than $5 million market value) eliminates any statistically significant size effect during the sample period using a regression framework.”
The studies appear to question the existence of the small-cap premium, but they fail to answer one fundamental question: what happens if you remove the junk?
Watch your junk
Small caps are naturally risky, and the majority of them flame out, but famous small-cap investors such as Peter Lynch and Warren Buffett made a name for themselves by buying the best small caps and ignoring the junk. With this in mind, a paper by Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz, And Lasse H. Pedersen published in 2015 tried to answer this key question.
The researchers find that the existing criticisms of the small-cap premium do hold true in most cases. The size factor, a weak historical record of performance in the US, and even more inadequate record internationally “makes the size effect marginally significant at best.” The authors also acknowledge that long periods of poor performance, the difficulty of investing in micro-cap stocks and the concentration of small returns in January make the small-cap premiums existence difficult to justify.
Nonetheless, the paper goes on to note that the majority of the studies on the topic of the small-cap premium so far “load strongly and consistently negative on a large variety of “quality” factors.”
As determined in the paper Quality Minus Junk, following from the Gordon Growth Model, quality stocks are safe, profitable, growing, and have high payout ratio and outperform junk stocks over the long term.
Stocks with very poor quality (i.e., “junk”) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality. By controlling for junk, the authors of this small-cap study find that a robust size premium is present in all time periods, with no reliably detectable differences across time from July 1957 to December 2012.