The Case Against Small Caps

Testing Alternative Metrics to Market Capitalization

June 2019. Reading Time: 10 Minutes. Author: Nicolas Rabener.

SUMMARY

  • The performance of the Size factor in the US was positive since 1926, but not particularly attractive
  • Returns in Europe were more favorable, but not in Japan
  • Alternative metrics to market capitalization would not have resulted in better performance

SMALL VERSUS LARGE STOCKS

In the David vs. Goliath scenario, a smaller, weaker character faces down and defeats a larger and stronger opponent. Such triumphant underdog storylines abound in the realm of business: Think Netflix vs. Blockbuster, Alibaba vs. eBay in China, or Amazon vs. Barnes & Noble.

For small companies, survival is much more of a struggle than for their larger, more established counterparts. Their greater challenge is reflected in higher business risk. In the US stock market, the smallest 10% of companies by market capitalization exhibited annualized volatility of 15.3%, compared to 14.1% for the largest 10%, according to data going back to 1926 from the Kenneth R. French Data Library.

Investors naturally expect to be compensated for holding riskier stocks. But the Size factor, which represents a strategy of buying small-cap stocks and shorting large caps, has not generated attractive returns over the last 90-plus years. But maybe market capitalization is the wrong metric. Could different measurements of size have generated better performance? (read Factor Returns: Small vs Large Caps)

METHODOLOGY

We focus on the Size factor in US, European, and Japanese stock markets. The long-short, beta-neutral portfolios are created by selecting the top and bottom 10% of stocks ranked by their size, which is measured via five different metrics: market capitalization, enterprise value, average daily value traded (ADV), total assets, and total sales. Only stocks with a minimum market capitalization of $1 billion are included. Portfolios are rebalanced monthly and each transaction incurs costs of 10 basis points.

THE LONG VIEW

Returns from the Size factor have been almost flat since 1926, with some significant boom-and-bust cycles. The first influential paper on excess Size factor returns