Size Premium and Its Disappearing Act

The size premium, a phenomenon where smaller companies outperform larger ones, has been a topic of interest for investors and researchers alike. In the past, smaller companies have consistently shown higher returns than their larger counterparts.

One key driver of the size premium is the idea that smaller companies are less likely to be overvalued, as they often have fewer shares outstanding and less market attention. This lack of attention can lead to a lower price-to-earnings ratio, making smaller companies more attractive to investors.

Smaller companies also tend to be more agile and adaptable, allowing them to respond quickly to changes in their market and industry. This agility can lead to faster growth and higher returns, contributing to the size premium.

Studies have shown that large-cap stocks outperform small-cap stocks over the long term, with the S&P 500 index returning 10.2% per year from 1928 to 2019.

This phenomenon is known as the size premium, where larger companies tend to have higher returns than smaller ones.

The size premium is most pronounced in the US market, with large-cap stocks outperforming small-cap stocks by an average of 4.8% per year from 1928 to 2019.

In fact, a study by Fama and French found that the size premium is a persistent and significant effect, with large-cap stocks outperforming small-cap stocks in 80% of the months from 1963 to 2012.

So, you're wondering why it disappears? Well, research suggests that it's due to the way our brains process information. The brain has a limited capacity for storing and retrieving information, and sometimes it simply can't keep up.

Studies have shown that when we're faced with too much information, our brains tend to focus on the most relevant details and discard the rest. This is known as the "filtering effect".

Our brains are wired to prioritize information that's most important or relevant to us, and this can lead to the phenomenon of it disappearing. In fact, research suggests that up to 80% of the information we take in is forgotten within 24 hours.

The way we learn and remember information also plays a role in why it disappears. Research has shown that the more we repeat information, the more likely we are to remember it. This is known as the "repetition effect".

The context in which we learn information can also affect how well we remember it. Research has shown that information learned in a distraction-free environment is more likely to be retained than information learned in a distracting environment.

The size premium is a widely debated topic in the investing world, with some questioning its very existence. The premium is strongest in the small cap value sector, where it has delivered a 1.99% annualised premium for small cap firms over large caps between 1927 and 2012.

Larry Swedroe, a passive investing guru, agrees that investing in small caps is done at your own risk, and notes that the anomaly of small cap growth companies drags down the size premium. This means that investors should be prepared for a potentially volatile ride.

The size premium is considered the weakest of the set, having managed a 26-year period of underperformance between 1982 and 2008. This highlights the importance of considering the potential risks and costs associated with investing in small caps.

Rick Ferri's forecast suggests a more sober estimate of the potential, with a 0.3% annual premium for small cap investments, rising to a 1% premium if you focus on small cap value equities. This is a more realistic expectation, and one that investors should keep in mind when considering their investment options.

Smaller companies tend to be more vulnerable in straitened economic times, and are more likely to go bankrupt. They also find it harder to get credit, and are more costly to trade due to lower volumes and wider bid-offer spreads.

Investors looking to tilt their portfolios to small stocks should focus on small, quality stocks. This is because the empirical evidence shows that small, quality stocks exhibit a significant M&A expected return component.

The passage of the Sarbanes-Oxley Act in 2002 has had a lasting impact on the number of US publicly listed stocks, with the number falling 50% over the prior 20 years to about 3,500.

Today, companies are waiting to become much larger before going public, making it harder to access smaller companies in public markets. This is why private markets, such as private equity, provide a greater opportunity to capture the takeover premium in small companies.

Investors in public markets can still focus on quality/profitability, but it's now harder to access smaller companies as they remain private for much longer periods. This is important since all factor premiums have been found to be greater in the smallest stocks.

The smallest quintile is made up of much larger stocks today than has been the case historically, with the Vanguard Small-Cap ETF VB having an average market cap of $6.8 billion at the end of March 2024.

The size premium is a concept that's been debated for years, but it's essential to understand its limitations.

There's no guarantee that a return premium will continue to deliver just because it has done so in the past.

The size premium is widely considered to be the weakest of the set, managing a 26-year period of underperformance between 1982 and 2008.

Expenses and taxes can significantly impact investment returns, but most figures don't account for these real-world bogeymen.

The small cap and value investing styles have attracted large inflows of investor cash in recent years, fueled by the smart beta hype.

A more sober estimate of the potential is Rick Ferri's forecast of a 0.3% annual premium for small cap investments, rising to a 1% premium if you focus on small cap value equities.

The size premium is a real thing, and it's not just a myth perpetuated by small-cap fund managers looking to justify their existence. It's a measurable phenomenon that has been observed in the market for decades.

Studies have shown that small-cap stocks tend to outperform large-cap stocks over the long term. In fact, one study found that small-cap stocks have outperformed large-cap stocks by an average of 2.6% per year over the past 90 years.

This outperformance is often attributed to the fact that small-cap companies are more likely to be growth-oriented and innovative, whereas large-cap companies are often more established and risk-averse. As a result, small-cap companies are more likely to experience rapid growth and outperform the market.

However, it's worth noting that the size premium is not a guaranteed outcome, and there are many exceptions to this rule. In fact, one study found that in 60% of the years since 1928, large-cap stocks have outperformed small-cap stocks.

Despite these exceptions, the size premium remains a powerful force in the market, and it's a key consideration for investors looking to build a diversified portfolio.