The Truth About the Size Premium: Why It Still Exists If You Control for Quality
“The size premium is no longer existent.”
This is a snip from a conversation I had with someone this week who works for a fifty-billion-dollar investment manager.
Coming from someone who works for a firm that invests in robust equity investment factors (value, size, and profitability) I was taken back by the comment.
To this individual’s credit - I am aware that the premium since its discovery in the early 80s has weakened significantly but given risk-based theories of liquidity risk, limited analyst coverage, higher costs of capital, and behavioral risks of neglect effects, and institutional constraints I don’t believe the size premium is dead.
Which led me to turn to research available today to support the degree to which this claim was relevant.
Two papers stood out:
Understanding the Performance of Small Cap Stocks by Stanley Black, and Eric Geffroy
When looking at performance since 1979 the Russell 2000 slightly underperformed the large-cap Russell 1000.
Which doesn’t support the case of there being a size premium.
But when you pull back the layers, there is one theme that both papers outlined that instilled confidence back in the small cap premium - profitability.
If you sort small cap companies based on profitability you start to get a better understanding of attribution of returns in the asset class.
Small cap value companies with high profitability wildly outperform relative to small cap growth companies with low profitability.
Why is this the case?
This is likely the case from a variety of factors.
Investors overestimate future growth potential leading to overpriced stocks.
These overpriced stocks have frothy valuations and with weak underlying fundamentals the reinvestment of capital into speculative growth opportunities doesn’t generate the earnings required to meet shareholder demanded return.
These stocks have low margins and limited room for error - there’s a high expectation of growth and little cushion to absorb disappointments in earnings expectations.
Further - as markets enter downturns the lack of financial capital leads to further underperformance during bear markets as investors become less confident in future earnings.
AQR’s research similarly pointed out that quality, as measured by a combination of profitability, consistent and sustainable revenue and earnings growth, low leverage, strong balance sheets, and returns of capital through dividends, also provided statistical confidence in the robustness of the small cap value profitability premium.
So what does this tell us?
The size premium exists, but predominantly when you control for quality.
What this doesn’t mean - is that you should exclusively hold this asset class at the expense of your overall portfolio.
Any factor such as value, profitability, or size can potentially enhance long-term portfolio returns but should be incorporated in a portfolio that’s broadly diversified, systematic, and cost-efficient to increase the probability of higher long-term returns.
But how much of an overweight do you hold?
Depends on your investment taste and preference.
How much tracking error relative to the market are you willing to accept?
Further - how confident are you that these factor premiums will appear in the future?
After all - the world is different today than it was in the early 90s - who's to say market dynamics haven’t reflected that?
All investment principles still stand - but this is a powerful tool as you look to build portfolios that provide robust long-term returns.
In the words of Cliff Asness:
Size matters if you control for Junk.