The Investment Scientist

The Disappearing Small Cap Value Premium

Posted on: May 15, 2020

The Premium
The small cap value premium is a Nobel Prize-winning discovery about the stock market by Eugene Fama and Kenneth French. (Only Fama was awarded the Nobel Prize in 2013.) The original paper “The Cross-Section of Stock Returns” was published in the Journal of Finance in 1992. Using stock market data from 1963 to 1990, Fama and French found that small cap stocks outperform large cap stocks (small cap premium) and value stocks outperform growth stocks (large cap premium). Collectively, they are referred to as the small cap value premium.

Since the paper was published, many researchers have done out-of-sample studies and they found that this market feature persists in the data from 1928 to 1963, in the data from 1990 to as late as 2010, and even in foreign stock markets. So in academic jargon, this is a very robust feature of the market. (See chart below.)

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The Efficient Market Explanation
Academics in the camp (with Eugene Fama as their leader) believe that the stock market is efficient, and the extra returns small cap and value stocks are fetching are simply fair rewards for their extra risk. 

The Irrational Market Explanation
Another group of academics believe the market is simply irrational. They have rather consistently underestimated the potential of small cap value stocks and positive surprises bring extra returns.

Why The Debate Matters
If the premium is a fair compensation for risk, then this market feature (long-term outperformance of small cap value) will persist. If the premium is simply due to market mispricing, once this mispricing is well-known, investors will take advantage of this feature until it disappears (or reverses.)

My Quest to Understand
In four out of the last five years, small value stocks underperformed large cap growth stocks. The urgent question is whether the small cap value premium will persist or reverse. You would think with Eugene Fama winning the Nobel Prize, the debate would have had a clear winner. Not so! In my finance class at Oxford, I pointedly asked my professor this question, and he said the debate is still raging on. In my next article I will discuss an alternative explanation of small cap value outperformance.

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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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