Sunday, April 01, 2007

Small Cap & Value Premium

The rationale for "value" and "small cap" premia, following the research of Fama and French, continues to be debated. In their original study, using market data from 1964, they conclude that small-cap and value stocks outperformed large-cap and growth stocks. Fama and French concluded that since small and high book to market companies outperformed larger and growth companies, size and value must be proxies for risk. Despite arguments that their research suffered from sample selection bias, further research across different time periods and markets provided additional support for the existence of these premia.

In their new research paper, Migration , Fama and French provide additional insight into the source of the premiums. They conclude;
  • The size premium is due almost entirely to the extreme positive returns of a small number of small stocks that migrate to large stocks through substantial outperformance from one year to the next.
  • Three factors contribute to the value premium. (i) value stocks that improve because they are acquired by other firms or because they earn high returns and so migrate to a core or growth portfolio; (ii) growth stocks that earn low returns and as a result move to a core or value portfolio; and (iii) slightly higher average returns on value stocks that remain in the same portfolio compared to growth stocks that do not migrate.
  • The value premium is somewhat offset by small growth stocks that are more likely to become big than small value stocks from year to year. The average returns from these transitions are huge, and their greater weight in the small growth portfolio pushes up its average return and lowers the value premium.
This work parallels some of the statistical evidence and intution regarding equity investing strategies. Managing downside risk is important - value investing tends to limit downside risk while the primary risk in growth investing, according to this research, is downward migration.
It is difficult to ouperform large cap value benchmarks- picking the winners or avoiding the lossers in this category does not seem to have a large impact on excess returns. The larger dispersion of returns in small caps confirm the importance and value of having exposure to the winners each year. Active small cap managers have the opportunity to provide large excess returns but must be skilled or lucky since large performance penalties exist for being wrong.

source: Mark Hulbert NYT


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