The Size Premium Lives, But Not for All Small-Company Stocks
Thursday, February 22, 2018

One driver of stock price returns debated among research papers is the size premium. The size premium—also known as small minus big (SMB)—is the historical outperformance of small-company stocks relative to large-company stocks. The continued existence of this so-called anomaly has been called into question because of the essentially equal returns between small- and large-company stocks since 1982.

The data gives both opponents and proponents of the small-cap premium facts to base their arguments on. Since the 1981 publication of Rolf Banz’s Journal of Financial Economics study, “The Relationship Between Return and Market Value of Common Stocks,” aggregate returns have stopped showing a longstanding premium. Rather, a portfolio of equal-weighted large-company stocks realized an annualized return of 12.3% versus the 12.2% annualized return for an equal-weighted small-company portfolio. (I used Dartmouth professor Kenneth French’s data library for the return data.)

Proponents of the size premium, however, can point to other data. Over the longer period of 1927 through 2017, small-company stocks had a 4.5 percentage-point annualized return advantage (14.9% versus 10.4%). Grouping stocks by value versus growth (or high versus low momentum) provides evidence of the premium’s continuing existence. A recently updated study by Clifford Asness of hedge fund AQR Capital found that grouping stocks by quality also shows that the demise of the size premium is greatly exaggerated.

I’ll start with value versus growth. Between 1927 and 2017, an equal-weighted portfolio of small-company value stocks with book-to-market ratios ranking in the cheapest 30% of all exchange-listed stocks realized an annualized return of 18.8%. This compares to a 13.3% annualized return for large-company value stocks. (Value is defined as a high book-to-market ratio, the inverse of a low price-to-book ratio.) By means of comparison, small-company growth stocks (the 30% with the most expensive book-to-market ratios) returned just 8.0% and large-company growth stocks returned just 9.5% on an annualized basis.

Limiting the data to the post-Banz study era of 1982–2017 shows evidence of the size premium continuing to live. Small-company value stocks have realized an 18.4% annualized return versus 14.1% for large-company value stocks, 11.6% for large-company growth stocks and 5.5% for small-company growth stocks.

In a recent revision to their paper, “Size Matters, If You Control Your Junk,” Asness and his co-authors used quality instead of value to separate stocks. Over the period of July 1926 through December 2012, they found that quality minus junk (QMJ) portfolios had a small-company premium of 0.22% per month. This equates to approximately 2.7% in annualized excess return. The advantage disappeared between January 1980 and December 1999, but reappeared between January 2000 and December 2012 with a 0.42% monthly premium (5.2% annualized).

Since I recently updated my historical analysis on momentum for my presentation slides, I decided to look at the numbers for the post-Banz period on a high versus low momentum basis. Again, the data showed the continued existence of the size premium. Between 1982 and 2017, an equal-weighted portfolio of high-momentum small-company stocks had an annualized return of 18.8% versus 14.7% for a portfolio of high-momentum large-company stocks. This 4.1 percentage-point premium is smaller than the longer-term (1927–2017) premium of 4.6 percentage points for high-momentum small-company stocks, but it is still significantly large. (Notably, the size premium has vanished for low-momentum stocks. Between 1982 and 2017, low-momentum small-company stocks have an annualized return of 7.6% versus 8.0% for low-momentum large-company stocks.)

The time periods I used and the periods Asness and his co-authors used are obviously not the same. What is the same are the conclusions: The size premium does continue to exist if one goes beyond simply comparing all exchange-listed large-company stocks to all exchange-listed small-company stocks. For investors—both individual and institutional—the big takeaway is not to simply have a broad exposure to small-company stocks, but rather to target small-company stocks with traits associated with long-term outperformance. Such traits include low valuation, high momentum and good quality.

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Highlights from this month's AAII Journal

The Week Ahead

Many retailers will report earnings, including Macy’s Inc. (M) on Tuesday, Lowe’s Companies Inc. (LOW) on Wednesday and Best Buy Co. Inc. (BBY) on Thursday. Joining them will be nearly 30 other members of the S&P 500, including Priceline Group Inc. (PCLN) on Tuesday.

The week’s first economic report will be January new home sales, released on Monday. January durable goods orders, January international trade, the December S&P Corelogic Case-Shiller home price index and the Conference Board’s February consumer confidence survey will be released on Tuesday. Wednesday will feature the first revision to fourth-quarter GDP, the February Chicago Purchasing Managers’ Index (PMI) and the January pending home sales index. On Thursday, January personal income and spending, the February PMI Manufacturing Index, the ISM’s February manufacturing index and January construction spending will be released. The University of Michigan’s final February consumer sentiment survey will be released on Friday.

Three Federal Reserve officials will make public appearances this week: St. Louis president James Bullard on Monday, Jerome Powell on Wednesday and New York president William Dudley on Thursday.

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AAII Sentiment Survey

The percentage of individual investors describing their short-term outlook for stocks as “neutral” is at its highest level in three months. The latest AAII Sentiment Survey also shows a decline in optimism and a small increase in pessimism.

Bullish sentiment, expectations that stock prices will rise over the next six months, pulled back by 3.9 percentage points to 44.7%. Even with the decline, optimism remains above its historical average of 38.5% for the 10th time in 11 weeks.

Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, rose 2.5 percentage points to 32.6%. Neutral sentiment was last higher on November 23, 2017 (35.5%). The increase puts neutral sentiment above its historical average of 31.0% for the first time in 12 weeks.

Bearish sentiment, expectations that stock prices will fall over the next six months, rebounded by 1.4 percentage points to 22.8%. Pessimism remains below its historical average of 30.5% for the 10th time in 11 weeks.

At current levels, all three indicators are within their typical historical ranges.

Many individual investors are watching interest rates, monetary policy and bond yields. (Most of this week’s results were tabulated before the minutes from the February Federal Open Market Committee meeting were released.) Earnings growth also remains at the forefront of AAII member’s minds. Tax cuts are giving some individual investors reason to be optimistic, while others are uncertain or skeptical about the impact that the new law will have on growth. Also influencing sentiment are politics and valuations.

This week’s special question asked AAII members what portfolio action, if any, they took in response to the recent market correction. The majority of respondents (62%) said they didn’t make any change or only made a small change. Many of these respondents described themselves as being focused on the long term, viewing this month’s correction as being only temporary in nature or not severe enough to warrant any action. A few of these respondents described the correction as lasting too short of a time for them to take advantage of it. Nearly 33% respondents said they took advantage of the decline to buy stocks or funds. Some said they took advantage of the reduced prices to either add to current positions or buy new holdings. Just 7% of respondents said they sold stocks during the correction. A small number of respondents said they sold some positions and then bought new positions.

Here is a sampling of the responses:

  • “I did not take any action because the economy is still strong. The correction seemed temporary.”
  • “I bought stocks. Why? They were on sale.”
  • “I bought three positions that I had my eye on.”
  • “I sat on my hands. It has worked for 30 years.”
  • “I took no ‘action,’ however, several of my stocks were stopped out rather naturally.”
  • “Bought a little. The correction was mild, I didn’t have time and valuations would have to be better to do more.”


This week’s Sentiment Survey results:

Bullish: 44.7%, down 3.9 points
Neutral: 32.6%, up 2.5 points
Bearish: 22.8%, up 1.4 points

Historical averages:

Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
Take the Sentiment Survey.

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