Small Versus Large Cap Stocks: Exploring the Size Premium

The belief that small cap stocks should outperform their larger counterparts has long been held in the investment world since Rolf Banz first revealed the size premium in 1981. Historical data from 1962, as analysed by Fama and French in their 1992 paper, shows that the smallest 30% of US stocks have outperformed the largest 30% by an average of 0.19% monthly. Even after controlling for valuations, the size premium remains robust at 0.17% monthly.

Key points in this paper include:

• US small cap stocks have outperformed large-cap stocks by an average of 0.19% per month since 1962.
• Key reasons for this size premium include i) small firms are more adaptable and have higher growth potential, ii) higher risk warranting greater compensation, and iii) takeover premiums.
• The size effect does have significant time variations which are typically driven by economic cycles (interest rates) and investor sentiment.
• Small caps typically underperform in the stages of an economic cycle and during recessions and outperform early in economic recoveries when sentiment is optimistic.
• In Australia, small caps have historically underperformed large caps by 0.26% per month since 1995, which is contrary to the US size premium.
• Despite this long term relative index underperformance, Australian small caps provide large alpha opportunities for active managers due to the market inefficiencies and high dispersion in this segment of the stock market.
• The Australian median manager, according to most studies, beats their benchmark by around 5% p.a. This is highly dependent on the commodity cycle, as the typical manager has a quality bias and is underweight Resources. Coupled with recent accelerated divergence in favour of large caps, we consider Australian small caps a core portfolio allocation.