The Small-Cap effect

During my years on p123, I’ve seen many discussions about the small-cap effect, whether it’s still valid, coming back, etc.

FYI, Here’s my latest blog on the subject:

Thanks for the link.
It has given be a large perspective on the issue of small caps.

Thank you!!!

Cool article! From what I’ve seen, the size effect is not particularly interesting by itself, but rather ‘amplifies’ other known anomalies such as value, quality, profitability, etc.

Personally, I agree with this 100%: I think you’ve hit the nail on the head. I believe O’Shaughnessy makes much the same point in What Works on Wall Street.

A few other points are worth making.

  1. Marc’s discussion of economies of scale and business portfolios is right on the money. And it’s a point I’ve rarely seen made.

  2. As Marc has pointed out, smaller stocks are far riskier than larger ones by almost any measure. Not only are they more likely to go under, their returns are going to be less predictable and less steady. And, as Marc wisely points out, their fundamentals are going to be more volatile.

  3. Small stocks are more likely to be mispriced than larger stocks. They have fewer analysts following them and, due to low liquidity, price moves can be excessive. There’s simply not as much price arbitrage going on.

  4. Small stocks have lower earnings than large stocks. Using measures like P/E to compare small stocks to large ones are therefore going to be flawed. The percentage of small stocks with negative earnings is much higher than that of large stocks. They’re therefore going to do worse than large stocks by most measures of profitability and/or quality: ROE, profit margin, etc.

Marc has long maintained that the criteria one uses to choose large stocks and small stocks are quite different, and, despite my initial resistance, I’ve gradually come around to share his belief. I too thought his article was excellent, and made some long overdue points.

I think this is true as is the rest of the above discussion.

Followers of the CAPM would ask: “Do small-cap offer improved risk adjusted returns?” I am not sure about that. Maybe but I am not sure. Truly unsure and not willing to take either side of a discussion on this.

I have tried to look at this but mostly with backtests that are anecdotal at best.

I can say that I have changed my universe (and some of my factors) to not favor small-caps anymore. Instead, I look at the specific factors and fundamentals that Marc, and Yuval mention above—whether the stock is large-cap or small-cap.

For my ports, favoring small-caps could have even been called overfitting. Overfitting that was not working as well out-of-sample as it did in the backtest.

Has anyone else changed their universe?