PMC Weekly Review – January 22, 2019
After a tumultuous end of the year, many investors are revisiting their portfolio allocations and have probably noticed the stark underperformance of domestic small cap stocks versus their large cap counterparts. Small cap stocks, which generally have a market cap between $300 million and $2 billion, were down 11.01% at the end of 2018, according to the Russell 2000 Index. Comparatively, the Russell 1000, representing the large cap category, was down 4.78%. Although investors may be tempted to shift towards more established, larger companies, small cap stocks have earned a place in portfolio allocations, especially for the long term.
Investing in small cap stocks provides many benefits and return opportunities, including greater potential upside, as these companies are generally in their infancy years. Smaller companies are more focused and nimble, allowing them to take advantage more readily of market trends and opportunities. This could mean faster growth and expansion, translating to strong stock returns. Small cap stocks receive less coverage by research analysts, which can lead to mispricing relative to their intrinsic value. Additionally, large companies often are looking to expand into new channels or take out competitors, making smaller companies prime acquisition targets. Besides the philosophical reasons to invest in small caps, academic research has closely examined the small cap, or size bias, as a market anomaly.
The size factor, noted as “SMB” or “Small minus Big” by practitioners, is the tendency for companies with lower market equity to outperform those with higher market equity. In practice, portfolio managers overweight smaller capitalization companies while shorting or underweighting larger ones within a universe. Having first been identified almost 40 years ago, the size effect first became well known through Eugene Fama’s and Kenneth French’s academic paper, “The Cross-Section of Expected Stock Returns,” which found that a three-factor model considering size, value, and beta, was better at predicting portfolio returns then solely the capital asset pricing model (CAPM), or beta. In Fama’s and French’s study, stocks were sorted into 100 different portfolios based on size, after accounting for the tendency for smaller stocks to exhibit higher beta. The results determined a high correlation between size and average return. In a later paper, “Anomalies with a Five Factor Model,” Fama and French added the investment and profitability factors, and found that the combination could explain upwards of 90% of stocks’ expected return. In both studies, the size effect played an important role. Risk-based theorists argued that smaller companies are more susceptible to economic events, less able to access financing, and generally have less liquidity, meaning there are additional sources of risk that must compensate investors. Others viewed the research as challenging the hypothesis of market efficiency and deemed the effect as an anomaly.
But as small cap stocks have struggled over recent time periods, critics have begun to reevaluate the notion that simply tilting towards companies with lower market equity positions portfolios for success. One widely noted criticism is that the data that Fama and French used was incomplete for small companies, in that those that had been delisted were not included. Companies can be delisted from indices for a number of reasons, but small caps are disproportionally affected. Thus, the negative returns for these companies were not included and could have skewed the realized returns for small caps. However, the main conclusion of Fama and French was that stock risks are multidimensional, not that the size effect should be considered in a vacuum. In fact, in a recent paper “Size Matters if you Control your Junk,” it was determined that high-quality small caps outperform high-quality large caps. Screening for liquidity and eliminating OTC stocks mitigates delisting risks, whereas using the other factors, such as value, profitability, and investment, uncovers small cap leaders.
Whether investors believe the size effect is truly a market anomaly or simply has diversification benefits, it has added 3.2% annually over a 20-year period in domestic equities (as measured within the Russell 3000 Index as of 12/31/18, QRG factor Data), encouraging a patient and long-term view. Investors may want to consider including a small cap allocation in their portfolio, and the sell-off at the end of 2018 may indicate an attractive entry point.
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