The Investment Scientist

Posts Tagged ‘small cap

ImageAccording to Nobel Laureate Eugene Fama, there are three major risk premiums.

1. Equity premium is the additional “wage” one can earn from taking stock market risk over not taking stock market risk.

2. Small cap premium is the additional “wage” one can earn from taking small company risk over taking large company risk.

3. Value premium is the additional “wage” one can earn from taking non-growing company risk over taking growing company risk.

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ImageSince its inception on March 9, 2003, RSP has returned 193%. At the same time, SPY has only returned 97%. This is extremely puzzling as both RSP and SPY hold the same S&P 500 stocks.The only difference is that SPY is a cap-weighted fund and RSP is an equally-weighted one. This begs the question, is RSP’s outperformance normal; and more importantly, is it likely to continue?

To answer the question I asked my intern Nahae Kim to run a regression based on the Nobel Prize winning Fama-French Three Factor Model.

R(x) – rf = alpha + beta1*(Rmkt – rf) + beta2*SML + beta3*HML

Where R(x) is the return of the selected fund, x being either RSP or SPY, alpha is the “skill” of the fund, beta1 is the market risk loading, beta2 is the small cap risk loading and beta3 is the value risk loading.

Here is what I got from the two regressions.

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If you invested $1 in the small cap value index at the beginning of 1927, you would have had $52,892 by the end of 2010. This is according to the recently published Dimensional Fund Advisors’ annual Matrix Book. Included in the book are historical risk and returns of various indices based on capitalization and book-to-market valuation.

Table 1 presents a summary of historical returns. The best returns are marked in green; the worst, marked in red. As one can see, the small cap value index is the best for all the periods considered. And it is the best by a huge margin.

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icarra chart

MZ Capital 40/60 model vs S&P 500

Just like two sides of a coin, the capital market is made up of capital demanders (businesses) and capital suppliers (investors). What for businesses are costs of acquiring capital are for investors rewards of supplying it. It is a simple truth that

Costs of Capital = Expected Returns

Looking through this lens, many capital market phenomena can be explained.

Why small stocks tend to have higher returns than large stocks?

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In January 2008, I wrote in my article “Recession and stock market performance” that:

Small cap value stocks are likely to outperform.

With one week left in 2008, the Russell 2000 Value Index, representing small-cap value stocks, has lost 34%. This is bad, but not as bad as the S&P 500 Index’s 41% loss and the Nasdaq 100’s 43% loss this year. The S&P 500 Index represents the largest 500 stocks in the U.S. and the Nasdaq 100 represents the largest 100 growth stocks.

Since January, I’ve heard pundits recommending large-cap stocks, tech stocks, pharmaceutical stocks, etc. Never once have I heard them recommend small-cap value stocks, which they claim are the most vulnerable in a recession.

Do I have a better crystal ball?

No, I don’t. I simply know the odds. As I wrote in “Small-cap value underperforming: a historical perspective,” the odds that small-cap stocks will outperform large-cap growth stocks on aggregate in any given year is 75%. So I can make the same “prediction” year after year and still be right about 75% of the time.

Why do most investors shun small-cap value?

According to Daniel Kahneman, father of behavioral economics, certain types of information are more accessible than others to the human mind. For instance, the concept of probability is not intuitively accessible, but descriptive words like “small,” “large,” “value” and “growth” leave instant impressions on our minds.

Another discovery of Kahneman is that humans take mental shortcuts in decision making. Confronted with the choice between large-cap growth and small-cap value, most investors eschew the hard route of calculating odds. Instead, they rely on their intuition that “large” is safer than “small” and “growth” has more potential than “value.” Thus, they “decide” to shun small-cap value stocks.

Small-cap value premium

An undesirable job has to pay more to attract job-seekers. Likewise, a shunned asset class commands a higher expected return in equilibrium. As long as small-cap value is not an intuitively attractive asset class, this return premium will continue.

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Author

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

Twitter: @mzhuang

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