The Size Premium is Alive and Well

Is the lack of a size premium due to the performance of small-growth stocks in general? Or is it due to penny stocks, IPOs, stocks in financial distress and lottery-like small-growth stocks (those with poor profitability and high investment)? Several recent studies answer those questions.

Let’s begin by looking at the data that shows the disappearance of the size premium, with a focus on small-growth stocks. Then I will discuss three research studies that collectively show why the size premium should not be written off by advisors.

A major anomaly for the capital asset pricing model (CAPM) and the competing asset pricing models (such as the Fama-French three-, four- and five-factor models as well as the Q-factor model) is the performance of small-growth stocks. As you can see in the table below, using data from Ken French’s data library, small-growth stocks have had by far the worst performance among the four asset sub-classes, despite experiencing far greater volatility than large-growth stocks. And small-growth returns were well below those of small-value stocks, while experiencing virtually the same volatility. The rest of the data shows returns positively correlated with risk (large value has provided higher returns than large growth and small value higher returns than small growth).

The performance of small-growth stocks has been so poor that over the 50-year period ending 2018, they underperformed even long-term Treasury bonds (6.5% versus 7.9%) while experiencing more than twice the volatility (25.8% versus 12.0%). Over the same period, large-growth, large-value and small-value stocks returned 9.8%, 11.5% and 14.0%, respectively.

Such poor performance has also been found for penny stocks, stocks in bankruptcy and IPOs – all have experienced lower returns than we would expect (i.e., are anomalies for asset pricing models and market efficiency). Behavioralists explain these outcomes as the result of the “lottery effect,” or a preference for investments that exhibit positive skewness in returns. Positive skewness occurs when the values to the right of (greater than) the mean are fewer but farther from the mean than are values to the left. In other words, investors are willing to accept low average returns in exchange for the possibility of getting some extremely positive outcomes. You can think of it as investors searching for the next Google or Apple.