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Has the Small-Cap Premium Disappeared?

On Friday, we discussed an article on small-cap stocks that appeared in the latest issue of Financial Advisor, which argued that the small-cap premium doesn't actually exist. Today, we'll continue our discussion by taking a look at the small-cap premium in the "post-Banz" era.

What makes the efficient markets hypothesis so powerful is that the discovery and exploitation of anomalies (inefficiencies) causes them to shrink and eventually disappear. However, if a premium exists because of the existence of greater risk, the premium should be expected to persist -- at least before the fact.

In 1981, Rolf Banz published his dissertation, "The Relationship Between Return and Market Value of Common Stocks," which documented higher average returns for common stocks of small companies relative to large companies. Many people have since questioned the results based on the performance of small caps in the post-Banz era. Unfortunately, there's a lot of misperception out there. Let's see if we can clear things up.

First, Banz found that from 1927-1981, average returns increase monotonically from the largest stocks to the smallest stocks. The largest decile had average returns of 10.0 percent per year, while the smallest decile returned 24.3 percent per year.

In the post-Banz era, 1982-2010, the pattern of returns is similar (though flatter) than in the early period. The largest stocks have an average return of 12.5 percent per year versus 15.6 percent per year for the smallest stocks. This 3.1 percent return difference is smaller than in the earlier sample. However, there's too much noise in this estimate to say with any statistical confidence that the size premium has declined since 1981. The pattern we observe in the data can be an artifact of chance. Given that there's not enough data to conclude that the size premium has changed, using the full sample will yield the most precise estimate of the size premium. Over the period from 1927-2010, the smallest decile of US stocks outperformed the largest decile by 10.4 percent annually.

Photo courtesy of DonkeyHotey on Flickr.


Explanation of Shrinking Premium There are other possible explanations for the shrinkage of the premium. The first has to do with the timing of Banz's study and the fact that valuations matter, as they impact future returns. In 1975, small-cap stocks began a period of dramatic outperformance which ended in 1983. What many would call a bubble developed in small caps as prices were driven higher and higher. Of course, all bubbles burst in the end, and future returns are lower. Banz's study just happened to roughly coincide with the end of the bubble. Consider the following:
  • For the period 1926-74, the largest decile of stocks returned 9.8 percent per year, and the smallest returned 21.8 percent per year, a gap of 12 percent.
  • For the period 1975-81, the largest returned 12.8 percent per year, and the smallest returned 37.6 percent, more than doubling the gap to almost 25 percent.
Clearly the higher valuations caused by the dramatic outperformance during the period narrowed the expected return differential.

There's yet another explanation to consider. Over time, our capital markets have become more liquid. We've also seen tremendous advancements in technology and an increase in competition. The result is that the bid-offer spreads and commissions to trade small-cap stocks have shrunk dramatically. Thus, we should expect to see the small-cap premium shrink. However, we shouldn't expect to see the premium disappear, as there are still liquidity risks, greater bid-offer spreads, larger market-impact costs and well-documented risk explanations for the small-cap premium. For example, small-cap stocks are more volatile and more sensitive to overall market movements. And they're more exposed to systematic default risk and business cycle risk.

Photo courtesy of jmorgan90 on Flickr.


Small-Cap Evidence Premium The academic literature also provides some other explanations for the performance of small-cap stocks in the post-Banz era.

Poor Performance of New Stocks The study "New Lists: Fundamentals and Survival Rates" showed that there has been a dramatic increase in the number of newly listed firms on major U.S. exchanges, and these newly listed stocks (especially those that are small) have performed badly. This raises the possibility that a "bad draw" occurred and the poor performance of the new lists wasn't anticipated by the market before the fact.

More Competition Several studies have concluded that there has been an unprecedented increase in the level of competition due to industry deregulation and trade liberalization. They found that there's evidence suggesting that big firms are better equipped than small firms to cope with the challenges and opportunities in the new competitive environment. Another study, "Stock Price Reaction to News and No-News: Drift and Reversal After Headlines," found that firms that experienced good news are on average much bigger than firms that experienced bad news during the 1980s and 1990s.

Profitability Shocks The 2010 study "Profitability Shocks and the Size Effect in the Cross-Section of Expected Stock Returns," found that small firms experience large negative profitability shocks after the early 1980s, while big firms experience large positive shocks. As a result, realized returns of small and big firms over this period differ substantially from expected returns. After adjusting for the price impact of profitability shocks, we find that there still is a robust size effect in expected returns.

Considering Value and Growth There was a small premium across the spectrum of stocks when ranked by book-to-market. In the pre-Banz period:

  • Small-cap growth stocks (15.6 percent) outperformed large cap growth stocks (10.5 percent).
  • Small-cap neutral (17.2 percent) outperformed large-cap neutral (11.7 percent).
  • Small-cap value (19.8 percent) outperformed large-cap value (15.7 percent).
In the post-Banz period, positive small-cap premiums are robust among neutral (3.7 percent difference between small-cap neutral large-cap neutral) and value (4.8 percent difference between small-cap value large-cap value) stocks. However, among growth stocks, the relation is reversed. Small-cap growth underperforms large cap growth by 3.6 percent (12.9 percent versus 9.3 percent) on average. And the smaller the market cap of growth stocks, the greater the underperformance.

The conclusion that we can draw from all is the evidence is that the suggestion of the disappearance of the small-cap premium is mostly a story about the underperformance of small-cap growth - a story behavioralists explain as a preference for investments with lottery-like distributions.

The bottom line is that while the size of the small-cap premium seems to have become smaller, the small-cap premium appears to be alive and well.

Photo courtesy of Rev Stan on Flickr.
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