What is “size premium”? The size premium is the extra amount of return that small companies offer versus investing in large companies. In 1992, Eugene Fama and Kenneth French designed a model that explained stock market returns. The model included a few factors, but the one we will focus on is the size premium.
Technically, if all stocks were fairly priced the size premium should not exist and is therefore an anomaly. The prevailing theory to explain the anomaly is that small companies are riskier and investors reasonably expect that the more risk they take, the larger the potential returns. However, the size premium has failed to deliver in the past decade.
An historical review
Often, too many investors are chasing the same size premium and we should avoid investing in small companies. Surely 10 years of failing to deliver extra return and taking more risk in the meantime is evidence enough, right? This conclusion would ignore 93 years of data that suggest otherwise. The dataset we use defines large companies as the top 50% most valuable companies listed on the NYSE, AMEX, and NASDAQ exchanges, and small companies as the bottom 50%. The return advantage/disadvantage is then based on the difference between the average performance of the small and large companies. Data shows that extended periods of lulls in small company performance are interrupted by dramatic periods of outperformance. Over these past 93 years, the brief periods of outperformance have accrued a 7 times return advantage over large companies. The performance is measured both ways, meaning that if large companies are down 30% and small companies are down only 20%, then the measured outperformance of small companies is 10%. If large companies are up 30% and small companies are up only 20%, then the measured underperformance is -10%.
Let’s take the period from 1956 to 1965, when small companies added barely any extra return over that period. The 3 years following that period, small companies offered twice the return. Admittedly, there was a pullback, but then small companies continued a 6-year long period of outperformance afterwards. Sometimes the return advantage whipsaws over a decade and adds no extra return, as experienced in the ’90s. The point is that there are many occasions when an investor could have concluded that the size premium no longer exists, but then be sharply proven wrong when small companies are favored. This begs the question: how do we take advantage of this?
A compelling value opportunity
As long-term investors, we recognize that styles of investing such as small versus large companies go in and out of favor. Our systematic rebalancing strategy is designed to take advantage of changing valuations. Our allocation to small companies is a function of many varied sources of information, but primarily based on valuations relative to other asset classes and itself. Though we cannot predict when small companies will begin to outperform large companies, we feel that they continue to offer diversification benefits and a compelling value opportunity.
Additional Important Disclosure Information
The index returns shown above show the total return for various investment indices and include the impact of the reinvestment of dividends. A comparison to indices may not be a meaningful comparison. Comparisons to benchmarks have limitations because benchmarks have volatility and other material characteristics that may differ from the performance of a client’s portfolio. The investments in a client’s portfolio may differ substantially from the securities that comprise each index and are not intended to track the returns of any index. One cannot invest directly in an index, nor is any index representative of any client’s portfolio. Actual client accounts will hold different securities than the ones included in each index. The index returns are gross of applicable account transaction, custodial, and investment management fees. The actual investment results would be reduced by such fees and any other expenses incurred as an investor.
Important disclosure information
Please remember that different types of investments involve varying degrees of risk, including the loss of money invested. Past performance may not be indicative of future results. Therefore, it should not be assumed that future performance of any specific investment or investment strategy, including the investments or investment strategies recommended or undertaken by RegentAtlantic Capital, LLC (“RegentAtlantic”) will be profitable.
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This article is not a substitute for personalized advice from RegentAtlantic. This article is current only as of the date on which it was sent. The statements and opinions expressed are, however, subject to change without notice based on market and other conditions and may differ from opinions expressed in other businesses and activities of RegentAtlantic. Descriptions of RegentAtlantic’s process and strategies are based on general practice and we may make exceptions in specific cases.
RegentAtlantic does not provide legal or tax advice. Please consult with a legal and or tax professional of your choosing prior to implementing any of the strategies discussed in this article.