Is There A Size Effect In The Stock Market?

One of the oldest and most persuasive arguments in the stock market is that small stocks outperform large stocks.(1) Warren Buffett, speaking at the 2013 Berkshire Hathaway Annual Meeting, summarized the sentiment when discussing the disadvantages of managing a huge amount of capital:

There’s no question size is an anchor to performance.

The implication is that managing a huge asset base prevents an investor from exploring the more intriguing opportunities available in smaller and more illiquid stocks.(2)

We agree with Buffett: having a fat wallet makes it tough to outperform. If investors are focused on long-term outperformance, small stocks are a good place to find outsized returns. Of course, you still need a solid underlying investment process – small stocks won’t cure bad ideas.  But coupling a reasonable process with smaller stocks can be a wonderful approach. For example, almost all popular investment factors, to include value and momentum, have historically worked much better in smaller stocks than they do in mega-cap stocks.

And while Warren Buffett’s quote seems to suggest that the debate over the outsized potential of small caps is settled, it turns out there is a substantial debate on the topic. Investors looking to make more informed portfolio decisions should be aware of these arguments before grasping small caps with both hands.

A Short History of the “Size Effect”

First, a little history on the research into the so-called “size effect.” Rolf Banz pioneered the exploration of the size premium in his 1981 paper, “The Relationship Between Return and Market Value of Common Stocks.” Prof. Banz found that, on average, small cap stock portfolios outperform large cap portfolios on a risk-adjusted basis. This research is often cited as the original “size effect” paper, but even in this original work the good professor highlights that there are 1) no theoretical foundations for the size effect and 2) his results could be proxying for a hidden factor. In other words, further research needed to be conducted.

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Moon Kil Woong 9 months ago Contributor's comment

The market is driven by general rules but is also driven by perception. The very large caps have performed better than the large and medium sized companies in recent years. They even outperformed small caps in various times. This has been driven by the sense of increased safety and liquidity it offers along with being a favorite of managed and mutual fund managers. Is this a long term abnormality? In tech I think not, large cap companies are able to more easily effect change and innovation in the industry and often buy and build out successful technologies these days.

As for the rest of the market, most likely. The other issue is small companies have been hurt most by rising health insurance and regulations. Thus, the environment for small caps have not been all that great and this sector is one of the sectors who have most benefited by Republican pushes to roll back regulatory constraints and paperwork. As I mentioned, this is a moving target, thus one study or even a series will not always be right about this sector compared to others. Indeed, if there is heavy anti-monopolistic regulatory action in Washington many big caps will suffer and things can move heavily towards small caps again not because they are growing stronger but because large caps may be seen as riskier decreasing their appeal.