The size premium

The size premium

by Pininvest Analysis

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Size is one of the factors in the Fama–French three-factor model describing stock returns, along with book value and market risk

In the model, historic excess returns of small-cap companies over large-cap companies drives the expected rate of market return, along with risk premium and excess return of value stocks

It has been argued the premium benefiting stocks of firms with smaller market capitalizations over firms with larger market capitalization could not persist

As the premium became recognized, it was not unreasonable to assume the differential would be arbitraged away, eliminating the historical outperformance of small cap stocks

But in an Ibbotson Associates study, published by Morningstar, Mr. Annin and Mr. Falaschetti argue the premium will not fade over an extended cycle

  • since the performance of small cap assets exposes the investor to more uncertainty (implying higher volatility), periods of underperformance should be expected
  • periods of underperformance could well last because of the relative ‘stickiness’ of small-cap stock performance, known as autocorrelation, describing the tendency of the return of one period to be related to the return of the previous period

The implication for the size premium is clear: because of its persistence over long periods (decades), realized returns may provide a suitable proxy for the risk premium, which impacts the discount rate and the valuation of the small company

Over short periods, on the other hand, evaluation of the size premium is fickle

  • as acknowledged in statistical reviews, periods of under-performance of small cap stocks are not unusual and even expected and auto-correlation would extend such periods
  • ‘small cap’ stocks can be sampled in many ways, with quite different returns, and to the extent that small public companies may in fact be distressed, the premium of the segment could become be even more vexing


Practical guidelines at pinindices

Analytical and heavy on comparisons, the approach featured by pinindices attempts to provide practical guidelines to the investor with a short to medium term horizon

  • Confronting performance history of any market segment with its average volatility
  • Comparing sub-indices of market segments ranked by size to get a ‘feel’ of relative performance and ‘relative’ volatility profiles
  • Remaining focused on the large vs low-mid cap stocks of the 1 200 Datavariance index, excluding the smaller, less liquid and in some cases distressed public listings

A rich example, shown here, records performance and volatility, market cap weighted, from Jan’ 1, 18

Confronting the smallest segment of 240 companies with the largest, the comparison documents market confusion following the February volatility run-up

Jan'18-Aug'18 Confronting market cap weighted smallest and largest sub-indices

It will be observed that while the small-cap premium found a surer footing from early June, it is hardly convincing when evaluated over a smaller timeframe of 3 months

June'18-Aug'18 A narrower focus on small vs large cap stocks