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The Small-Company Advantage: Fact or Fiction?

We examine both sides of the debate and offer ideas for how you might use small-company stocks in your own portfolio

Morningstar.co.uk Editors 5 July, 2013 | 7:00AM

Great things come in small packages. It's not only a cliche--it's a principle that many people invest by. Smaller companies are more nimble and volatile than large companies, they note. So smaller companies must offer better returns than larger companies. Besides, they point out, there's evidence to back up the idea of a small-cap premium.

Yes, there's evidence, but it stands on shaky ground. Many financial professionals now question whether there really is any advantage to investing in small-company stocks.

This lesson examines both sides of the debate and offers ideas for how you might use small-company stocks in your own portfolio.

What Is the Small-Cap Premium?

The idea of a small-cap premium is more than three decades old. In 1981, a newly minted Chicago Ph.D. named Rolf Banz published "The Relationship between Return and Market Value of Common Stocks" in the Journal of Financial Economics. The conclusion was startling: between 1931 and 1974, small-company stocks had thrashed the market's giants.

This new evidence dovetailed beautifully with Modern Portfolio Theory. MPT argued that risk was linked with return. Since small-cap stocks unquestionably carried higher risks than large-cap stocks, it would only be logical for them to deliver higher returns.

Cracks in the Argument

By the late 1990s, cracks began to appear in the small-cap thesis. Several critics noted that the small-cap premium that Banz discovered owed to a handful of performance bursts, not to consistent outperformance. And those bursts can be few and far between. As a result, an entire generation of investors can miss out on the superior return that small-company stocks supposedly offer.

Others attacked Banz's conclusions more directly, claiming that the "excess" returns of small-company stocks disappear after you take the higher transaction costs into account.

Finally, the harshest criticism emerged. A paper called "The Delisting Bias in CRSP's Nasdaq Data and Its Implications for the Size Effect" (by Tyler Shumway and Vincent Warther) suggested that Banz's database was just plain wrong. The paper's authors point out that the standard academic stock-market database, Center for Research in Security Prices, which Banz used, fails to account for stocks that are delisted by stock exchanges for performance-related reasons. As a result, CRSP overstates performance.

Just how greatly performance is overstated depends on the company. As companies shrink, they become increasingly likely to be chopped by an exchange's axe. Shumway and Warther find that over their 18-year study period (from 1977 to 1994), 5.6% of all Nasdaq stocks were delisted each year. Applying an average loss of 55% to each delisted stock--a figure the authors arrived at after a lot of footwork--shaves the equal-weighted returns for Nasdaq by a sizable three percentage points per year.

Continuing our Nasdaq example, the effect becomes even greater in the smallest stocks. On average, nearly 3% of the smallest 5% of Nasdaq companies get delisted each month. Over a year...well, you do the maths. After correcting for the delisting bias, the authors find "no evidence that there was ever a size effect on Nasdaq."

But Shumway and Warther's paper doesn't completely invalidate the small-company argument. Their study covers only one period and one stock exchange. In 1987, Shumway found that adjusting for the delisting bias for Nasdaq's sister exchanges, the NYSE and AMEX, did not eliminate the small-cap effect.

Since Banz didn't actually study Nasdaq (his original paper drew on NYSE data), the more recent paper doesn't actually refute his findings. But the paper's results do raise the question of how valid it is to extend Banz's findings to small-cap stocks, in general. Perhaps Banz found an effect peculiar to the composition of the NYSE at that particular time, rather than a universally generalisable lesson about a premium for all small-cap stocks.

What Investors Can Do

So should you even bother investing in small-company stocks? Yes, but not because you expect them to deliver better long-term results than large-company stocks. If they do, well, that's icing on your investment cake.

Instead, own some small-company stocks for the diversification they provide. Small companies do, in fact, behave differently than large-company stocks. Small companies are thus great choices for diversifying a portfolio. 

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About Author

Morningstar.co.uk Editors  analyse and report on shares, funds, market developments and good investing practice for individual investors and their advisers in the UK.