Is Small Cap Investing Proper for You?

Are you on the lookout for larger returns in your investments? Effectively, if you wish to go huge, you then would possibly simply need to go small.

What I’m speaking about known as “small cap investing,” or investing in shares with market capitalizations of lower than $2 billion. Traditionally, investing in small cap shares offered a better fee of return than bigger, extra established firms. This phenomenon is called the small cap premium (or measurement premium).

Nonetheless, the query stays as as to whether this premium nonetheless exists in right now’s market. On this weblog publish, we’ll delve into the historical past of the small cap premium, look at whether or not it’s a worthwhile technique, and reply the query, “Is small cap investing best for you?”

However, earlier than we try this, let’s first present slightly historical past in regards to the origins of the small cap premium.

The Historical past 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 Worth of Widespread Shares”, which was printed within the 1981 Journal of Monetary Economics. As acknowledged within the paper’s summary:

It’s discovered that smaller companies have had larger danger adjusted returns, on common, than bigger companies. This ‘measurement impact’ has been in existence for no less than forty years and … the principle impact happens for very small companies whereas there may be little distinction in return between common sized and huge companies.

Banz’ discovery was adopted by the creation of the Russell 2000 index in 1984 and extra analysis replicating his findings within the years that adopted. Particularly, Eugene Fama and Kenneth French included the small cap premium of their landmark 1992 paper, “The Cross-Part of Anticipated Inventory Returns”, which cemented its legacy as an element that might outperform the general inventory market.

On the asset administration aspect of issues, Dimensional Fund Advisors got here out with their U.S. Micro Cap Portfolio (DFSCX) in the identical 12 months that Banz’ paper was launched (1981). So far as I can inform, DFSCX is the oldest fund that invests solely in small cap shares. Technically, T-Rowe Worth has a Small Cap Stock Fund that was established in June 1956, however I’ve been unable to confirm whether or not this fund has invested solely in small cap shares for its whole historical past. Given the novelty of Banz’ paper in 1981, I doubt T-Rowe Worth was utilizing an analogous technique greater than twenty years prior.

Now that we have now taken a have a look at the historical past of the small cap premium, how huge is it anyway?

How A lot Do Small Shares Outperform By?

Since 1926, U.S. small cap shares have had an actual return of 8.4% per 12 months in comparison with 7% per 12 months for the general U.S. inventory market. Which means the small cap premium has averaged about 1.4% per 12 months for practically a century. Nonetheless, this outperformance has not been constant over time.

We will see this within the plot beneath which exhibits the rolling distinction in annualized returns over 10 years between small cap shares and the broader market (S&P 500) since 1926:

As you may see, in some intervals small cap shares outperformed all U.S. shares and in different intervals they underperformed by important margins. Nonetheless, many of the intervals the place small cap shares underperformed appear to have occurred after 1980.

We will see this extra clearly if we plot the annualized actual inventory returns for small cap shares and the S&P 500 by decade:

From the chart above there are two issues to notice:

1. There hasn’t been a single decade from 1930-2019 the place small cap shares (as a complete) misplaced cash.
2. From 1930 to 1979, small cap shares outperformed the S&P 500 in each decade besides the Fifties. Nonetheless, from 1980 to 2019 small cap shares underperformed the S&P 500 in each decade besides the 2000s.

This supplies proof that the small cap premium has not been constant over time although it has been principally constructive.

Nonetheless, the upper returns generated by small cap shares include a price—larger danger. Since 1926, the usual deviation of annual returns for small cap shares was 32% in comparison with solely 21% for U.S. shares general. You may see this extra clearly by trying on the drawdowns for small cap shares and the broader market all through historical past:

Whereas small cap shares and the general U.S. inventory market have a tendency to say no collectively in periods of market volatility, as you may see within the plot above, small cap shares have a tendency to say no a bit extra when the market crashes. Particularly, in the course of the Thirties, the Seventies, and, most just lately, the 2020s, small cap shares declined greater than bigger shares as traders fled to safer property.

Now that we have now checked out how small cap shares have carried out all through historical past, let’s focus on whether or not the small cap premium will live on sooner or later.

Will the Small Cap Premium Exist within the Future?

Although there may be proof of the small cap premium current all through historical past, current knowledge means that this will not be the case. As I discussed above, although small cap shares typically outperformed the S&P 500 in each decade from 1930-1979, they typically underperformed the S&P 500 in each decade from 1980 onward. Although we don’t know precisely why this occurred, Aswath Damodaran, the famed valuation skilled, offered some theories in this blog post:

Whereas the premium was robust previous to 1980, it appears to have dissipated since 1981. One cause could also be that the small cap premium research drew consideration and investor cash to small cap shares, and within the course of led to a repricing of those shares. One other is that the small cap premium is a aspect impact of bigger macroeconomic variables (inflation, actual development and so forth.) and that the conduct of these variables has modified since 1980.

However Damodaran doesn’t cease there. He goes on to listing a handful of different the reason why the small cap premium could not exist sooner or later (and why it could by no means have existed within the first place both):

• When you exclude absolutely the smallest shares (these with market capitalizations beneath $5M), the small cap premium disappears.
• When you exclude the month of January, the small cap premium disappears.
• When you exclude U.S. shares, there may be far much less proof of a small cap premium.

And so forth. Damodaran’s article highlights why it’s troublesome to say for positive whether or not the small cap premium will live on within the years forward.

The latest knowledge means that there was a constructive small cap premium since 1980, however it’s a lot smaller than it was once. We will see this if we plot the rolling distinction in annualized returns over 20 years between small cap shares and the general U.S. inventory market since 1926:

Although this plot means that small cap shares have offered larger returns than bigger shares over the previous 20 years, this doesn’t imply that investing in small cap shares is a free lunch. As demonstrated above, small cap shares are typically riskier than their bigger counterparts. Due to this fact, given this extra danger, I’d count on smaller shares to have larger returns than bigger shares.

Now that we have now examined whether or not the small cap premium is more likely to exist sooner or later, let’s wrap issues up by figuring out whether or not small shares are proper on your portfolio.

The Backside Line

Including smaller shares to your portfolio appears more likely to enhance your long-term returns considerably. Nonetheless, this extra return is not going to come with out extra danger. As illustrated above, when shares fall, small shares often fall extra. For that reason, I’m undecided small shares by themselves are the proper transfer for many traders.

Personally, I don’t put money into small-cap solely funds, however I’ve used measurement as a filter alongside different components when making funding selections. For instance, when investing in worth shares, I are likely to solely put money into small cap worth shares. The proof for together with measurement in live performance with worth is even stronger than for utilizing measurement or worth alone. As soon as once more, from Damodaran (emphasis mine):

Even probably the most favorable papers on the small cap premium recommend that it’s a must to add refinements with some suggesting that these refinements ought to display screen out the least liquid, riskiest small cap shares and others arguing for worth traits (steady earnings, excessive returns on fairness & capital, strong development).

As you may see, the dialogue on whether or not to personal small cap shares can get very complicated in a short time. Nonetheless, if you wish to dig deeper on this subject, I like to recommend studying Fact, Fiction, and the Size Effect from AQR. In any other case, ignore the small stuff and Just Keep Buying.

Comfortable investing and thanks for studying.

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That is publish 336. Any code I’ve associated to this publish might be discovered right here with the identical numbering: https://github.com/nmaggiulli/of-dollars-and-data