The Investment Scientist

The Disappearing Small Cap Value Premium 2

Posted on: May 15, 2020

images (3)In my economics class at Oxford, I learned a very important concept: technology by and large manifests diminishing returns to scale.

When economists use the term “technology”, they usually mean the method of production, that is, taking labor and capital as inputs, and outputting something valuable. For instance, there is a method by which I deliver my financial advisory service, economists would call that technology. It’s a catch-all term.

Diminishing returns to scale simply mean the bigger you are, the harder it is to make money at the same rate. Take my little practice as an example. It’s just me and my assistant. It can’t be smaller, but it’s super efficient. If we were a 20 person firm, I can’t imagine how I would manage all these people who all have their different agendas and motivations. The firm may make more money in the absolute term, but on a per head basis, it wouldn’t  be as profitable as my little practice. That’s the essence of diminishing returns to scale.

If the economy only has diminishing returns to scale technology, it follows that small companies should have higher returns than larger companies and non-growing companies should have higher returns than growing ones, since growing simply gets you diminishing returns.

Now most investors have not taken an economics class at Oxford, and they are blissfully unaware of the concept of diminishing returns. So they are constantly surprised by the better performance of smaller and non-growing companies. Yet they get negative surprises from bigger or growing companies. How about this as an explanation for the small value premium?

In the last ten years or so, there emerged a new type of company, one that doesn’t sell products or services, but instead provides a digital platform for various human activities. These companies and their platform participants form the new digital platform economy. What’s different about the digital platform economy (from the traditional economy) is that its technology manifests increasing returns to scale. The bigger the platform, the more popular it is, the more money the company can make, and the harder it is for a challenger to disrupt. In the last five years or so, a sizable portion of the economy has migrated onto these digital platforms and that might have spelled the end of the small cap value premium. In the post-pandemic world, I am afraid this migration will only accelerate.

Now to be totally honest, I have not won a Nobel Prize for this conjecture, so take it with a grain of salt. But in my own portfolio and my clients’ portfolios, I have made some changes in light of my learning at Oxford.

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1 Response to "The Disappearing Small Cap Value Premium 2"

To be clear, you’re basically saying “it’s different this time?” Famous last words.

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Michael Zhuang is principal of MZ Capital, a fee-only independent advisory firm based in Washington, DC.


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