The Small-Cap Premium Still Lives on the Value Side
by Charles Rotblut | March 30, 2017
Historically, small-cap stocks have outperformed large-cap stocks. This difference is referred to in investment circles as the small-cap (aka small-company) premium. The discovery of the small-cap premium is credited to Rolf Banz’s 1981 Journal of Financial Economics study, “The Relationship Between Return and Market Value of Common Stocks.” I specifically bring Banz’s study up because there has been a debate as to whether the publication of his study effectively destroyed the premium.
Between 1927 and 1980, small-company stocks realized an annualized return of 17.1%. Over the same time period, large-company stocks gained 9.3% annually. Using the formula of small minus big results in a rounded premium of 7.7%. 
(I’m using data from Dartmouth professor Kenneth French’s website for the smallest and biggest 30% of companies to calculate the returns.)
During the subsequent period 1981-2016, small-company stocks realized an annualized return of 11.8% and large-company stocks have realized an annualized return of 11.7%. This is the argument for Banz’s study having ended the premium. These numbers do not tell the full story, however. Further analysis reveals a different picture.
Between 1927 and 1980, small-company growth stocks (those with priciest valuations as measured by the book-to-market ratio, which is the inverse of the price-to-book ratio) realized a rounded 1.8 percentage-point premium relative to large-company growth stocks (10.1% versus 8.4% annualized returns). This premium was reversed over the 1981-2016 period, with small-company growth stocks underperforming their large-company counterparts 4.5% to 10.8% on an annualized basis.
The reversal of fortune does not exist among value stocks, however. Small-company value stocks realized a 6.4 percentage-point premium over the large-company value stocks for the period of 1927 through 1980 (19.1% versus 12.7% annualized). During the latter period of 1981-2016, this premium has largely been maintained (18.4% versus 14.1% annualized).
What the data clearly shows is that the reward is in the small, value quadrant. Even with the post-Banz-study reduction, the premium for owning small-company value stocks remains significant: 4.3 percentage points over large-company value, 7.6 percentage points over large-company growth and 13.9 percentage points over small-company growth.
There are caveats to consider to before loading up the truck on small-company stocks. The premium requires patience and a lengthy time horizon to capture. Small-company stocks have also been more volatile than their large-company counterparts. (Over shorter periods of time, small-company growth and small-company value stocks will underperform, decline in value and otherwise fray your nerves. This is the case with all categories of stocks, including large, growth, dividend paying, momentum, etc.) Premiums from anomalies (“factors”) are realized by those investors with patience and the ability to stick with a strategy for the long term. If you don’t feel comfortable committing to one style of investing, you can always tilt your portfolio by allocating some of it to small-company stocks and allocating the remainder to other investment styles.
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How Much Small Cap Should Be in Your Portfolio? – Small-cap stocks provide diversification benefits to a large-cap stock portfolio, but personal factors should influence how large the allocation to small-cap stocks should be.
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Exploiting the Relative Outperformance of Small-Cap Stocks – The small-cap premium has been most significant during periods of economic expansion.
Pessimism bounces back after two weeks of declining, according to the latest AAII Sentiment Survey. At the same time, neutral and bullish sentiment declined compared to last week.
Bullish sentiment, expectations that stock prices will rise over the next six months, fell 5.1 percentage points to 30.2%. The historical average is 38.5%.
Neutral sentiment, expectations that stock prices will stay essentially unchanged over the next six months, fell 1.8 percentage points to 32.4%. Despite the weekly decline, neutral sentiment remains above its historical average of 31.0% for the second consecutive week.
Bearish sentiment, expectations that stock prices will fall over the next six months, rose 6.9 percentage points to 37.4%. The increase pushed bearish sentiment back up above its historical average of 30.5%.
Since the beginning of the year, bullish sentiment has declined 16.0 percentage points, while neutral sentiment has risen 3.8 percentage points and bearish sentiment has risen 12.2 percentage points over the same time period. Both neutral and bearish sentiment remain above their historical average, while bullish sentiment remains below its historical average.
Markets dipped slightly over the last week as investors began to question President Trump’s ability to move forward with promised legislation. The doubt was sparked after House Republicans failed to vote on a replacement for the Affordable Care Act (aka Obamacare)—Trump’s first attempt to pass major legislation since being elected. Much of the market momentum since Election Day has been due to hopes that a new administration would enact policies favorable to the corporate environment and spur economic growth.
Last week’s special question asked AAII members how the market’s relative lack of downward volatility this year (just one day with a decline of greater than 1% through March 22) has affected their sentiment toward stocks. Forty-three percent of respondents said that the lack of downward volatility has made them more bearish in regard to their market outlook, while 38% were uncertain or neutral and 19% were bullish.
Here is a sampling of the responses:
- “A large correction is very likely in the coming months and is the reason that I am currently neutral over the next six months rather than bullish. Bullish is my current long-term position, however.”
- “Facts show that it is bullish despite popular belief.”
- “It has not affected my outlook at all, I look for long-term value.”
- “It all depends on Washington. I expect that Washington will not deliver all the market has priced in.”
- “I’m more reluctant to invest, taking small amounts of profits for buying on larger declines.”
Bullish: 30.2%, down 5.1 points
Neutral: 32.4%, down 1.8 points
Bearish: 37.4%, up 6.9 points
Bullish: 38.5%
Neutral: 31.0%
Bearish: 30.5%
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March 2, 2017 Investors Win as Discount Brokers Cut Commissions
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