The Size Factor in Stock Investing: A Critical Analysis
Historically, small-cap stocks have been perceived as outperforming their large-cap counterparts, leading to the concept of the “size” factor in academic literature. However, our analysis suggests that company size may not be a reliable indicator of superior returns.
Historical Performance
Comparing ETFs tracking the Russell 2000 (small-caps) and Russell 1000 (large-caps) over a 23-year period reveals a marginal outperformance of small-caps, which could be attributed to random variation. Over shorter horizons (10 and 5 years), small-caps drastically underperformed large-caps.
Arguments for Small-Cap Investment
Proponents of small-cap investing argue for greater growth potential and possible undervalued valuations. However, defining fair valuation is subjective, and small-cap discounts may reflect higher inherent risks.
Survivorship Bias and Structural Challenges
Survivorship bias skews small-cap indices, as many companies fail before reaching significant growth. Structural factors also favor large corporations, including access to capital, talent, and regulatory influence. Smaller companies face challenges in competing against their larger counterparts, limiting their potential for growth.
Conclusion
Investing in small-caps is not as straightforward as buying a diverse basket of stocks. Identifying strong companies and managing risks is crucial for generating alpha in this sector. Diligent investors can leverage the complexity of small-cap analysis to differentiate between winners and underperformers, potentially enhancing returns.
