There’s been plenty of debate about the small-cap value premium, an investment analysis first published by Eugene Fama and Kenneth French in a 1992 paper, “The Cross-Section of Stock Returns.”
Researchers analyzed market data ranging from 1963 to 1990. They learned that small-cap stocks tend to outperform those with a larger market cap. That phenomenon is dubbed the “small-cap premium.”
In addition, the researchers found that value stocks outperformed growth stocks, over time. Together these two discoveries are known as the “small-cap value premium.”
Various other academics delved deeper into the data set, and confirmed the findings.
The small-cap outperformance makes intuitive sense for several reasons. Small caps are often newer and scrappier. Management is motivated to grow the firm, and are adept at doing a lot with fewer resources. The small size of the company itself may mean management can be more nimble about pursuing projects that seem promising, and abandoning those that seem to be a dead end.
In addition, smaller market caps often mean less coverage from Wall Street analysts, which can increase volatility and perhaps erratic pricing. The few institutions who are invested may have less visibility into the company’s internals, and are investing with less information. That may cause wide price swings.
Is Small-Cap Premium Still Reliable?
The smaller number of shares outstanding can also mean it’s easier for one or two large holders, or even an organized group (think Reddit meme stocks) to push a stock’s price significantly higher or lower.
While the small-cap tilt has become a tenet of asset allocation strategies over the past three decades, there are some analysts and investors who doubt the reliability of this strategy. There are several theories as to why this may be. For example, some research revealed that the majority of the small-cap premium occurred in the month of January, suggesting that selling or seasonality could be at work.
In addition, other researchers posit that small cap investing was a more lucrative strategy in past decades, as gains were primarily driven by micro-caps, or stocks with capitalizations below $300 million. Over the decades, with a proliferation of small-cap funds, investment has piled into those with market caps above $300 million, perhaps leading to less upside volatility that may result in greater gains.
While investors may be skeptical of the small-cap premium for a variety of reasons, it’s always true that different asset classes cycle in and out of leadership. That’s normal market rotation. The inherent volatility of small caps can not only mean big gains, but also sharp declines.
Small Caps Outperforming in 2021
This year may prove fruitful for small-cap stocks. President Biden’s $1.9 trillion American Rescue Plan may prove beneficial to smaller companies, as these tend to supply goods and services to larger companies. In addition, these companies may see a greater proportional effect from consumer spending.
In addition, the ramping up of Covid vaccinations may also benefit smaller public companies, which learned how to quickily pivot during the pandemic. As businesses open up this year, these companies may be able to boost their profitability.
Of course, even with small caps, there is the question of value stocks vs. growth stocks.
So far, value is winning the 2021 race by a long shot.
Investors can never get too comfortable, as any given asset class doesn’t stay in leadership forever. But even if you’re a long-term investor with a strategically allocated portfolio that you maintain, it’s good to understand what’s driving your investment performance over the long haul.
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