After a Decade of Strong Large Cap Growth, Is There a Place for Small Value?
Two of the most-studied and well-documented phenomena in investment management are value- and small-cap-based strategies. Value investing (pioneered by Benjamin Graham and David Dodd in the 1930s) is based on the principle that patient, long-term investors can earn higher expected returns by investing in lower-valuation securities – those with a higher book-to-market ratio, for example. Small-cap investing (described by Rolf Banz in the early 1980s) similarly links higher expected returns with the size of a company – lower market capitalization companies have historically offered higher average expected returns than larger companies. As of late 2017, however, we are currently in a period where over the last 10 years smaller companies and more value-oriented stocks have both underperformed their “large cap growth” counterparts.
Any investor seeking to outperform a given index or benchmark must invest in a strategy that is meaningfully different from that index. However, by being different than a benchmark the investor must also accept the potential for underperformance along with the opportunity to outperform. “Small value” investors are currently experiencing a period where their portfolios may be lagging a core index like the S&P 500. Many benchmarks will have higher exposure to larger and more “expensive” growth stocks, which have seen very strong returns in recent years (technology stocks such as Google, Apple, Facebook, and Netflix being prominent current examples).
Studying the Data
To put in context the discrepancy between the (very) long-term historical premium offered to investors in small-cap and value stocks and the outperformance of large-cap and growth stocks in the last 10 years, we can compare the returns between large-cap growth and small-cap value stocks in the US back to the 1920s in several ways.