Are you looking for higher returns on your investments? Well, if you want to go big, then you might just have to go small.
What I’m talking about is called “small cap investing,” or investing in stocks with market capitalizations of less than $2 billion. Historically, investing in small cap stocks provided a higher rate of return than larger, more established companies. This phenomenon is known as the small cap premium (or size premium).
However, the question remains as to whether this premium still exists in today’s market. In this blog post, we will delve into the history of the small cap premium, examine whether it is a profitable strategy, and answer the question, “Is small cap investing right for you?”
But, before we do that, let’s first provide a little history about the origins of the small cap premium.
The History of the Small Cap Premium
The small cap premium was first publicly documented by Rolf Banz in his paper “The Relationship between Return and Market Value of Common Stocks”, which was published in the 1981 Journal of Financial Economics. As stated in the paper’s abstract:
It is found that smaller firms have had higher risk adjusted returns, on average, than larger firms. This ‘size effect’ has been in existence for at least forty years and … the main effect occurs for very small firms while there is little difference in return between average sized and large firms.
Banz’ discovery was followed by the creation of the Russell 2000 index in 1984 and more research replicating his findings in the years that followed. In particular, Eugene Fama and Kenneth French included the small cap premium in their landmark 1992 paper, “The Cross-Section of Expected Stock Returns”, which cemented its legacy as a factor that could outperform the overall stock market.
On the asset management side of things, Dimensional Fund Advisors came out with their U.S. Micro Cap Portfolio (DFSCX) in the same year that Banz’ paper was released (1981). As far as I can tell, DFSCX is the oldest fund that invests exclusively in small cap stocks. Technically, T-Rowe Price has a Small Cap Stock Fund that was established in June 1956, but I’ve been unable to verify whether this fund has invested exclusively in small cap stocks for its entire history. Given the novelty of Banz’ paper in 1981, I doubt T-Rowe Price was using a similar strategy more than two decades prior.
Now that we have taken a look at the history of the small cap premium, how big is it anyway?
How Much Do Small Stocks Outperform By?
Since 1926, U.S. small cap stocks have had a real return of 8.4% per year compared to 7% per year for the overall U.S. stock market. This means that the small cap premium has averaged about 1.4% per year for nearly a century. However, this outperformance has not been consistent over time.
We can see this in the plot below which shows the rolling difference in annualized returns over 10 years between small cap stocks and the broader market (S&P 500) since 1926:
As you can see, in some periods small cap stocks outperformed all U.S. stocks and in other periods they underperformed by significant margins. However, most of the periods where small cap stocks underperformed seem to have occurred after 1980.
We can see this more clearly if we plot the annualized real stock returns for small cap stocks and the S&P 500 by decade:
From the chart above there are two things to note:
- There hasn’t been a single decade from 1930-2019 where small cap stocks (as a whole) lost money.
- From 1930 to 1979, small cap stocks outperformed the S&P 500 in every decade except the 1950s. However, from 1980 to 2019 small cap stocks underperformed the S&P 500 in every decade except the 2000s.
This provides evidence that the small cap premium has not been consistent over time though it has been mostly positive.
Nevertheless, the higher returns generated by small cap stocks come with a cost—higher risk. Since 1926, the standard deviation of annual returns for small cap stocks was 32% compared to only 21% for U.S. stocks overall. You can see this more clearly by looking at the drawdowns for small cap stocks and the broader market throughout history:
While small cap stocks and the overall U.S. stock market tend to decline together during periods of market volatility, as you can see in the plot above, small cap stocks tend to decline a bit more when the market crashes. In particular, during the 1930s, the 1970s, and, most recently, the 2020s, small cap stocks declined more than larger stocks as investors fled to safer assets.
Now that we have looked at how small cap stocks have performed throughout history, let’s discuss whether the small cap premium will continue to exist in the future.
Will the Small Cap Premium Exist in the Future?
Though there is evidence of the small cap premium existing throughout history, recent data suggests that this may no longer be the case. As I mentioned above, though small cap stocks generally outperformed the S&P 500 in every decade from 1930-1979, they generally underperformed the S&P 500 in every decade from 1980 onward. Though we don’t know exactly why this happened, Aswath Damodaran, the famed valuation expert, provided some theories in this blog post:
While the premium was strong prior to 1980, it seems to have dissipated since 1981. One reason may be that the small cap premium studies drew attention and investor money to small cap stocks, and in the process led to a repricing of these stocks. Another is that the small cap premium is a side effect of larger macroeconomic variables (inflation, real growth etc.) and that the behavior of those variables has changed since 1980.
But Damodaran doesn’t stop there. He goes on to list a handful of other reasons why the small cap premium may not exist in the future (and why it may never have existed in the first place either):
- If you exclude the absolute smallest stocks (those with market capitalizations below $5M), the small cap premium disappears.
- If you exclude the month of January, the small cap premium disappears.
- If you exclude U.S. stocks, there is far less evidence of a small cap premium.
And so forth. Damodaran’s article highlights why it is difficult to say for sure whether the small cap premium will continue to exist in the years ahead.
The most recent data suggests that there has been a positive small cap premium since 1980, but it is much smaller than it used to be. We can see this if we plot the rolling difference in annualized returns over 20 years between small cap stocks and the overall U.S. stock market since 1926:
Though this plot suggests that small cap stocks have provided higher returns than larger stocks over the past 20 years, this doesn’t mean that investing in small cap stocks is a free lunch. As demonstrated above, small cap stocks tend to be riskier than their larger counterparts. Therefore, given this additional risk, I would expect smaller stocks to have higher returns than larger stocks.
Now that we have examined whether the small cap premium is likely to exist in the future, let’s wrap things up by determining whether small stocks are right for your portfolio.
The Bottom Line
Adding smaller stocks to your portfolio seems likely to boost your long-term returns somewhat. However, this additional return will not come without additional risk. As illustrated above, when stocks fall, small stocks usually fall more. For this reason, I’m not sure small stocks by themselves are the right move for most investors.
Personally, I don’t invest in small-cap only funds, but I have used size as a filter alongside other factors when making investment decisions. For example, when investing in value stocks, I tend to only invest in small cap value stocks. The evidence for including size in concert with value is even stronger than for using size or value alone. Once again, from Damodaran (emphasis mine):
Even the most favorable papers on the small cap premium suggest that you have to add refinements with some suggesting that these refinements should screen out the least liquid, riskiest small cap stocks and others arguing for value characteristics (stable earnings, high returns on equity & capital, solid growth).
As you can see, the discussion on whether to own small cap stocks can get very complex very quickly. Nevertheless, if you want to dig deeper on this topic, I recommend reading Fact, Fiction, and the Size Effect from AQR. Otherwise, ignore the small stuff and Just Keep Buying.
Happy investing and thank you for reading.
This is post 336. Any code I have related to this post can be found here with the same numbering: https://github.com/nmaggiulli/of-dollars-and-data