How to make the most of the small-cap size effect
Over the past 30 years a number of investors and academics have been categorical about the power of investing in small companies. As a result, the size effect - the notion that small stocks outperform large stocks on average over time - has become an investing truism. But is that fair?
An interesting feature of the size effect - or the small-cap effect - is that it hasn’t always had the same level of scrutiny as return drivers like value, momentum, quality and even volatility. So in many ways it has had a free pass.
This is interesting because research suggests the size effect may not exist in the way many think it does. And where it does exist, it needs to be combined with other factors to get the most out of it.
Charting the history of the size effect
The size effect was first revealed in a study by Rolf Banz back in 1981. He’d looked at US stocks over 40 years and found better returns in smaller firms. To his credit, assessments of his findings - like this one from Alpha Architect - agree with what he saw in his own tests.
More recent work, like the studies by Elroy Dimson, Paul Marsh and Mike Staunton, see the size effect as an important anomaly. Their long run charts show that micro-caps and small-caps have outpaced large-caps in the UK and US over several decades. But there have also been spells in between when the reverse was true.
Other studies have found that the size effect only works in January, that it only works in micro-caps and that it’s actually a proxy for liquidity. In fact, some studies suggest the size effect completely disappeared just after Banz published his paper.
Against this backdrop, a general view has prevailed that smaller companies are an attractive asset class, especially for individual investors.
Some believe that investors with smaller pots of capital can get in and out of small-caps much more easily than larger institutions. Because of that, small-caps attract less professional research, which is an advantage for those prepared to do their homework. But above all, there’s a sense that shares in smaller companies can deliver much, much greater gains than those in larger firms.
Why investors love small stocks
It’s the observation that smaller stocks can double, triple or indeed tenbag and beyond much easier than large stocks that underpins some of the most influential writing in this area. In his 1989 book One Up On Wall Street, the fund manager Peter Lynch put it simply when he wrote: “Big companies have small moves, small companies have big moves.”
Three years later, the popular British investor Jim Slater, echoed the same views in his book The Zulu Principle, where he wrote: “As elephants don’t gallop, you should give preference to companies with an small market capitalisation in the region of £10-£50 million, with an outside limit, in most cases, of £100m.”
In fairness to Lynch and Slater, their comments about small-caps were in the context of strategies that deliberately focused on fast growth. They used it as part of a wider strategic approach. The risk for regular investors is that they see small-caps in isolation without considering other factors. And this is exactly where the latest research on the size effect comes in...
Stronger factor returns from small-caps
A new study by Ron Alquist, Ronen Israel and Tobias Moskowitz at AQR Capital called Fact, Fiction, and the Size Effect dissects the reality. They find that, on its own, the size effect isn’t a strong market anomaly - and it has weakened since it was first discovered.
In line with previous claims, they also find notably better returns in small-caps in January, but at no other time of the year. And to the extent there is a premium for smaller firms, it looks to be focused in the five percent of the very smallest firms.
But an interesting twist to all this is that the AQR research did find that other factor premiums such as value, momentum and quality were stronger in smaller stocks - and this helped them outperform large stocks. They suggested this could be down to smaller shares having less liquidity, higher volatility and more retail investors associated with them - which could all exacerbate the return premiums.
So the overall finding was that when it comes to grappling with company size, small-caps can be be attractive not because they are small per se, but because they can see superior returns when they have high exposure to factors like value, momentum and quality.
Overall then, there’s an argument that the high profile of the size effect over the past 30 years is perhaps slightly undeserved. While a focus on smaller stocks forms the backbones of popular strategies, there is some nuance about what really makes small-caps attractive. The latest research suggests the size effect on its own is nowhere near as useful as factors like value, quality and momentum. But when you start mixing those factors together, there’s a stronger case for looking closer at smaller firms.
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There may be another explanation for the small-cap size effect too.
If a stock market has the property that the total capital is spread across the market and not concentrated in one or two stocks (a concept called "Market Diversity") then it can be shown that any portfolio which is weighted towards smaller cap stocks will out-perform a market-weighted portfolio over a long enough time period. This property emerges directly from the mathematics without any need to invoke liquidity or analysts or the month of January.
The simplest way to achieve this is to use an equal-weighted portfolio and to rebalance at regular intervals.
If you want to follow up on the mathematics behind this you need to google for "Market Diversity" but also include the search term "Stochastic Portfolio Theory" or Google will get confused and show you a lot of matches for Marketing Diversity - which is a completely different thing!
Note that there is a condition: the market must be diverse for the small-cap effect to be present. In practice this seems to be a very mild requirement - although the way that the U.S. market is developing with a small number of huge "FANG" stocks dominating the market capital does show that it can't be taken completely for granted.
I was looking at the index data since AIM was started in 1996. Actually the mid-caps significantly outperformed small caps over that period (FTSE 250 versus the FTSE Small cap index). The period covers the dot-com bust and the global financial crisis and is about 22 years. I couldn't get a micro-cap index (FTSE Fledgling) for that period. It is worth noting that the market size of the Small cap index and the FTSE Fledgling index is also small. So probably 10 of the largest mid-cap stocks are equivalent to the whole of the Small cap index. So the data can easily get skewed on the basis of whether there happens to be one or two strong small cap or fledgling performers in a period.
Since March 1996 (when AIM started) the FTSE Small cap index is up 148% while the FTSE 250 is up 414% both excluding dividends. The FTSE 100 is up 105% excluding dividends. The AIM All share is up only 8%. (From closing prices a couple of weeks back)
The bottom line is that I am somewhat cautious on the "small cap" effect. It may not be the case during periods with significant economic/financial issues. Perhaps because small cap stocks are less defensive and so not as able to hold their value. Small cap stocks also tend to be much more volatile.
I guess what I am saying is that I wouldn't necessarily trust that history will be repeated going forward. The success or otherwise of small cap indices and mid-cap indices depends on the companies that are in each index. The S&P 500 in the US has performed well as it has high quality and fast growing technology companies in it.
The really impressive index at the moment is the AIM100 index, which contains stocks with a mcap roughly in the range £180M-£5B. Since I joined Stocko I have tended to prefer stocks in the range £100M-£2B but I am beginning to think that I might lift the lower limit to £150M and maybe raise the upper limit to £3B or even £5B.
Although there are some very good high performing stocks below £100M they tend to have problems of spread/liquidity and high volatility, and I am finding that I can find enough good stocks above the £100M limit to not need to incur the extra hassle.
So the overall finding was that when it comes to grappling with company size, small-caps can be be attractive not because they are small per se, but because they can see superior returns when they have high exposure to factors like value, momentum and quality.
There's a clever fellow called Edward Croft who illustrated the same point from a different angle a short while ago in a five year review of the StockRanks
Annualised 5 Year SR performance by company size
Always good to get confirmations from different angles.
I like to invest in both. Large Caps for buy and hold and smaller caps for shorter term periods of closely watched growth spurts (with stop losses in place).
I'd like to say my ratio is 70 30, large stocks (NVDIA, Berkshire Hathaway, Apple, Airbus, BAe, etc.) and small Caps (Fevertree, RM, Versarien, TC Icap, Vela, Ten entertainment, etc,). I haven't checked the ratio for a while, but should do so.
Maybe I would get better returns with a higher weighting in the former group than the latter, with less work. But then I'd need to find something else interesting to do with my time :-)
That's my fundamental problem too. It seems as if I could get as good or better returns just using stockranks or screens but it's my hobby!
That's my fundamental problem too. It seems as if I could get as good or better returns just using stockranks or screens but it's my hobby!
LOL Richard - that has to go one step beyond a "first world problem" - oh my gosh, my investment strategy is insufficiently time consuming!!
(I absolutely know what you mean though!)
Interesting. I know not the point of the article, but the persistence of the “January effect” is amazing, as I would consider this must be an easy thing to front run/ arbitrage. I wonder if the January effect (particularly in microcaps) is as strong for UK investors as US investors - given the 5 April individual tax year end.
I am also addicted. Yes at 76 yrs old where is the competition? I am a small investor and my normal BUY deal is usually 1-2k. I concentrate on the AIM in UK, but I deal in Thailand and have a broker in Scotland and in Amsterdam. I have very strict stop loss rules, -10% [steady market] and -15% [market falling]. I know that I am consistently profitable but because I live partially off my earnings, and probably overtrade, I find it difficult to calculate annual profits. What I do record is my monthly wealth and I am happy to say that this has risen over the last 10 years. Present portfolio is ATT, PLUS, BUR, SOM, VCT, BGS, AHT, GAW, IGR, YOU, VRS, PHI, IPX, GROW. Just sold LTG, FDEV and NMC. I also sold UKOG and BPC 6 weeks ago without profit or loss but regret as they were quite exciting.
Be careful! With too small capitalization, the problem of liquidity could be very strong, and the size effect could only be theorical because of big spread and slippage.
David Dreman says that you should not trade a stock if your position is more than a small percentage of its average volume in dollars.
As a rule of thumb, for a portfolio of 20 to 30 positions you I would consider only equities that trades at least the size of the portfolio. For example, if your total equity portfolio is $100.000 you should look for stocks that trade at least $100.000 every day. This probably cuts off all companies below 50 million dollars of capitalization: small but not too small.
Jim O'Shaughnessy as well recommends to look for companies of at least 200 million dollars of capitalization, that correspond to about 1 million dollars of average volume in dollars.
Anyway, I think that average volume in money is the best measure of liquidity. To calculate it in Stockopedia, you need to download 3 month average volume in a spreadsheet and multiply it for the price (in dollars, euros, pounds or whatever you like).
Hardly anyone seems to be inclined to risk low liquidity stocks, so that suggests it should be where the opportunity lies.
I don't manage an OEIC, so no need to meet customer redemptions. There are very few circumstances where I anticipate having to rapidly liquidate all of my portfolio & most of my holdings are for years.
So if the right opportunities are there, I should in theory be able to have 20~50% of the portfolio in low liquidity stocks.
In practice, the smallest market cap stock I currently hold is about £30million & that is a small position.
However, it's an area I want to explore just as soon as I go full time.
I originally got into stocks during the dotcom era and what found out then applies ever since that if you get into a just becoming fashionable sub-sector at the right time every micro/small cap in the sub-sector goes up and often are multibaggers.
A current sub-sector that may be about to go is `boom` is cannabis.Over recent years an increasing amount of countries and USA states are legalising cannabis and many others are likely to follow.
Note former Tory leader William Hague is now calling for the legalisation in the UK having been for many years a hardline opponent of legalisation.
There are not that many listed Cannabis stocks out there which increases the scope for large stock price rises
I do something like that (using wide spreads as a positive screening criteria for a segment of my portfolio).
I find it strange that it is so unpopular: succesful illiquid investments will typically become liquid (infinitely so in case of a cash takeover, which is relatively common in that space), and the risk of being stuck in case of failure can be diversified away. Amusingly illiquid stocks include the failed hipster stocks of yesteryear that were liquid when they were hip.
jonesj
Your idea is supported by empirical evidence - illiquidity, a factor that most investors fear, appears to have been a large driver of returns across all market cap classifications.
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Good article. I like the way Stockopedia draws this kind of research to our attention.