I am only half kidding with the title above. This article adds some historical perspective to the Small vs. Large debate. Throw in the Value factor, which they do, and now the authors are speaking our language. While some might focus on the past and cry in their beer over the decade of Small losing out to Large, or Value losing out to Growth, we simply see opportunity going forward, and given we are fully committed to our style of investing and how we do it, we say, “Forward ho! History, and to a lesser extent time, is on our side.”

-Paul

The Size Factor

Small caps are trading at the steepest discount to large caps in decades

By: Dan Rasmussen, Brian Chingono, & Nick Schmitz

Over the past 50 years, small-cap stocks have returned, on average, about 2% per year more than large-cap stocks, according to Ken French’s data. The inclusion of the small-cap factor to help better explain stock movements was one of Nobel Prize–winner Eugene Fama’s biggest early breakthroughs.

This higher return, though, came with higher volatility. Over the past 50 years, large-cap stocks have had an annualized monthly volatility of 15% versus 21% for small caps, according to Ken French’s data.

Smaller companies have had higher bankruptcy risk (about 18% higher). They also tend to be more sensitive to economic conditions and, as a result of lower trading liquidity, experience bigger price swings. In theory, investors should be compensated for taking on these incremental risks.

But recently, investors in small-cap stocks have experienced heightened volatility but lower returns. Over the last five years, the S&P 500 large-cap index has had an annualized return of 14% with an annualized standard deviation of 21%, while the S&P 600 small-cap index has had an annualized return of 10% with an annualized standard deviation of 26%, meaning that small-cap investors got roughly half the return per unit of volatility as large-cap investors. The below chart shows the ratio of trailing five-year returns divided by trailing five-year annualized volatility of the S&P 500 large-cap index versus the S&P 600 small-cap index, with the grey line showing the delta between the two.

We’ve written before about problems with using volatility as a measure of risk. We show this simplified Sharpe ratio only to make the point that from the perspective of the conventional asset allocator, small-cap stocks haven’t looked as unattractive on a trailing basis in 20 years.

In fact, betting on Fama’s famed size factor has been a losing bet for over a decade. And small caps have had two periods—first during COVID in 2020 and then again this year—when they have lagged large caps by more than 20%. The below chart shows the cumulative excess returns of small companies relative to large companies, indexed to 100, starting in 2002…

Read the full article here.