Small Cap is Dead. Love Live Small Cap!

Returns for stocks are great everywhere you look in the developed world.  One of the best places though is in small US stocks.  The Russell 2000, the most common small cap benchmark is up 39.3 percent, much higher than the 32.4 percent return for the S&P 500 (through Dec 26).

Microcap stocks, as measured by Russell, are up an astounding 45.46 percent this year through yesterday.

In this context, it’s interesting that one of the common debates in academia is whether or not the small cap premium really exists.  Last week, I tried to explain the concept of statistical significance when evaluating returns.

In short, if you want to prove that a premium (one investment is better than another) is statistically significant, the premium has to be big or the volatility of the premium has to be small.

For example, consider the following three premiums:

Equity Risk          6.1          18.8
Value                    4.1          12.2
Size                        2.2          11.3

That table is showing you that – on average – stocks outperform cash by 6.1 percent per year, but the volatility of that outperformance is wild, plus or minus 37.6 percent per year (18.8 times two).

Using that same basic construct, small cap stocks outperform large cap stocks 2.2 percent per year – on average – but that’s plus or minus 22.6 percent in any given year.

The swings are so wide that they are obviously unpredictable in any single year, which is why we don’t attempt to time stocks, small versus large or value versus growth.

If we look at the statistics for the entire 87-year period that we have data, we can say with 99.1 percent confidence that the premium exists and isn’t a fluke in the data.

But, if we cut the data in half (a random operation for sure, but simple enough to get the idea across), the results aren’t so obvious.  In the first half of the data, 1926-1970 (or so), our confidence in the small cap premium is 96.9 percent.

However, the result from 1970 through October (academic data isn’t real time) is just 86.1 percent – below the common 95 percent threshold.

Many institutions argue that because it doesn’t pass the simple ‘split-test’ that the small cap premium may not really exist.

We’re not so sure about that hypothesis, but even if small cap doesn’t offer a premium, it certainly does create opportunity for diversification.  Value and momentum, for example, show up at different times in large and small cap.

This year, for example, value is stronger than momentum in large cap and it’s just the opposite for small cap (all out-performed their market-cap benchmarks; it’s a question of degree).

We see that the long-term data supports the idea of a small cap premium, but even with its weakness compared to the other equity premiums in shorter-periods, we still think that an allocation greater than the market weight is still sensible and appropriate.

Small cap is dead, long live small cap!