David and Goliath
Breathe easy, this will not be a wealth management group’s attempt at a full recounting of the biblical story of David’s victory over Goliath, although it is quite the tale. This will tell the story of an equally enthralling (for us finance buffs at least) underdog story playing out in a world of capital markets each and every day that trades are made: the battle between the returns earned by small stocks and large stocks.
There is a plethora of peer-reviewed, academic research into what drives the expected return of stocks. The price, which has the aggregate expectations of all market participants embedded in it, has emerged as the best proxy for informing which stocks have a higher expected return than their peers. Investors can use the information in prices to structure their portfolios in such a way as to pursue these drivers of higher expected returns. One of those drivers of expected returns is the size premium. Simply put, the size premium is the tendency of a certain subset of small-capitalization stocks to outperform their large-capitalization brothers and sisters. The market capitalization of a company is just the number of shares outstanding times the current market price; this measurement of size allows us to classify stocks into small-cap stocks or large-cap. Think of The Laurentian Bank of Canada as the David in this story and RBC as Goliath. RBC is nearly 80 times the size of Laurentian Bank based on market capitalization. Will the Laurentians of the world earn a higher return than the mega companies like RBC?
We can look to the historical performance to help inform our expectations of future. Looking at the graph below you will see that the Russell 2000 Value index, which represents US small value stocks, has outperformed the larger S&P 500, which is made up of the 500 largest companies in the US. Over the 41 year time period, the Russel 2000 value achieved an annualized return of 12.65% compared to the S&P’s 11.97%. Small’s outperformance continues to improve the further back in history you go.
Growth of $1 – S&P 500 vs. The Russel 2000 Value Index
01/01/1979 – 12/31/2019 – Returns in USD
Source: Dimensional Fund Advisors
Why the historical outperformance by the smaller stocks? The most intuitive explanation is that there is a greater degree of risk associated with owning small companies relative to large companies. There are multiple factors that drive this increased risk, but some of the important reasons include the fact that smaller companies have less resources to adjust to competitive pressures and economic slowdowns, they tend to have a greater level of debt relative to their assets, and they generally have a higher degree of volatility in their earnings. For an investor to be incentivized to own smaller stocks and bear this additional risk they need to be compensated in the form of higher returns. This is a fundamental principle of capital markets: if there was no incentive, why take the risk? It’s the same reasoning behind the higher expected returns associated with owning stocks versus fixed income.
So, if size premium exists, how do you capture part of it without bearing copious amounts of risk? This is where diversification and Dimensional’s approach really shine. Your Dimensional portfolio starts with the broad market and then slightly over-weights certain areas of the market that are expected to outperform, like these undervalued smaller stocks. By owning a portfolio that is “tilting” towards these areas instead of solely holding them, you maintain diversification, are well positioned to benefit from the premiums when they are realized and still get market-like returns when the premiums don’t show up. That’s the evidence-based advantage.