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 more closely at smaller firms.