In a previous blog post, I previewed several “factors” – characteristics of stocks – that can be utilized in portfolio construction to seek to improve equity (stock) returns over long periods of time (10-20 years) with a high degree of probability. This month I explore the “size factor” – also known as the small cap risk premium or the small cap factor.
History of the Size Factor
The concept of the size factor in investing can be traced back to the groundbreaking research of Rolf Banz, a financial economist, who published a seminal paper in 1981 titled “The Relationship Between Return and Market Value of Common Stocks.” In this paper, Banz observed that smaller companies, as measured by their market capitalization (the total value of their outstanding shares), tend to exhibit higher average returns compared to larger companies. This empirical finding, which came to be known as the “small firm effect,” challenged the conventional wisdom at that time, which suggested that higher returns were only achievable by taking on higher risk.
Banz’s research was later corroborated by other scholars, such as Eugene Fama and Kenneth French, who expanded on his findings and refined the concept of the size factor. Fama and French proposed a multi-factor model, known as the Fama-French Three-Factor Model, in the early 1990s, which incorporated the size factor as one of the three key factors, along with the market risk factor and the price (value) factor, to explain stock returns. The Fama-French Three-Factor Model provided further evidence of the size effect and helped establish the size factor as a well-recognized characteristic in the field of investing.
Since then, numerous studies have been conducted to examine the size factor in different markets, time periods, and investment styles, and the consensus among researchers is that the size factor is a fairly persistent and robust phenomenon in investing. However, it should be noted that the size factor works best when used in combination with other factors.
Reasons Behind the Small Cap Factor
The risk-based explanation for the size, or small-cap factor, posits that the size factor is driven by differences in risk characteristics between small and large companies. According to this view, smaller companies are riskier than larger companies due to various reasons, such as higher business risk, higher financial leverage, and less diversified operations. As a result, investors demand a higher return for taking on the additional risk associated with investing in smaller companies, which leads to higher expected returns for small cap stocks.
For example, smaller companies may have less established business models and may be more susceptible to economic downturns or industry-specific shocks, which can lead to higher volatility in their stock prices. Additionally, smaller companies may have less access to capital markets and may rely more on external financing, which can increase their financial risk. These risk factors can result in a higher cost of capital for smaller companies, which in turn can lead to higher expected returns for their stocks.
The behavioral explanation suggests that the size factor is driven by investor behavior and market inefficiencies. According to this view, investors may exhibit certain behavioral biases, such as overconfidence or herd mentality, which can lead to mis-pricing of stocks. In particular, smaller companies may be overlooked or undervalued by investors due to their relatively lower visibility, lower trading liquidity, and limited analyst coverage, which can create opportunities for astute investors to capitalize on the mis-pricing and earn higher returns.
For example, the limited information and coverage of smaller companies may lead to a lower level of attention from market participants. Investors may also have a bias towards larger, more well-known companies, assuming they are safer and more reliable, and thus, may overlook the potential of smaller companies. This can create market inefficiencies and mis-pricing, which can be exploited by investors who are willing to invest in smaller companies and take advantage of the higher expected returns associated with the size factor.
A Probability of Higher Expected Returns Over the Long Term
In summary, the size factor suggests that smaller companies, on average, may offer higher expected returns compared to larger companies over the long term. This implies that investors who are willing to take on the additional risk associated with small cap stocks may be rewarded with potentially higher returns. However, the best way to harness the effect of the size factor is not through picking just a handful of stocks in small companies, but by holding a mutual fund or exchange-traded fund (ETF) that invests in hundreds of smaller companies. In this manner, some of the risks of investing in smaller companies is “diversified away,” while retaining the higher expected long-term returns.
It is important to note that the size factor is not a guaranteed source of higher returns. However, it is fair to say that a highly diversified basket of small company stocks possesses, over any given 20-year period of time, a substantial probability of outperforming the overall stock market (as may be represented by a total stock market index fund).
Dr. Ron A. Rhoades serves as Associate Professor of Finance and Director of the Personal Financial Planning Program within the Gordon Ford College of Business at Western Kentucky University. He teaches and has taught courses in Retirement Planning, Applied Investments, Advanced Investments, Estate Planning, Financial Plan Development, Personal Finance, Money & Banking, Risk Management and Insurance, and Principles of Finance. He is regarded as a national expert in the application of fiduciary duties to the delivery of investment and financial planning advice. Ron’s upcoming book, Mastering the Science and Art of Investing: Strategies for Maximizing Returns with Multi-Factor Portfolios, is due to be published later in 2023.