The gist of the article is this:
- In the past decade, the total return of small-cap stocks has lagged that of large-cap stocks, contrary to academic research that demonstrates the long-term superior performance of small-caps. The same is true of value stocks when compared to growth stocks over the past ten years.
- Historically, however, the long-term out-performance of small-cap and value stocks has not occurred in every time period of 1 year or 5 years or even a full decade. In fact, under-performance occurs more often than intuition might suggest.
- Therefore, investors should not abandon small-cap and value stocks merely because of their recent under-performance in the past 1, 5, and 10 year periods.
To these cogent points, I would add three more.
First, investors should not over-invest in small-cap or value stocks unless they plan to hold them for a long time, at least 10 years. For example, if you are investing in a college-savings fund for your child, it would be better (on average) to invest in broad market averages, rather than betting that the next 5 to 15 years will be one of the periods when small-cap and value stocks show their muscle.
Second, there is some evidence in academic research that the advantage of value over growth is stronger for smaller stocks, and that the value-advantage is bigger than the small-cap-advantage. Thus, in addition to planning for a very long holding period, investors should focus on the combination of small size plus good value, rather than on either factor in isolation. Because of this research, Vanguard in their recent ETF for U.S. value stocks (VFVA) has a disproportionate number of small and medium sized companies. The average market capitalization is $32B, and more than half of the holdings are mid-, small-, and micro-cap firms. Other ETFs often do the opposite. For example, the holdings in iShares VLUE have an average market cap of $215B, and 88% of them are large-cap companies.
Third, it not always obvious how to invest in "small" and "value" stocks as defined in the research. Funds and benchmarks often digress from the academic criteria. The S&P 600 Small-Cap benchmark, for example, has a bias toward small companies that are profitable. Thus, funds using this benchmark are perhaps most accurately described as "small quality" rather than simply "small-cap." In contrast, funds benchmarked to the CRSP or Russell definitions of "small" really are exactly that.
For "value" the problem is more pervasive. Often, "value" funds are better described as "value + quality" or "current value + expect earnings-growth" or some other composite terminology. In the original academic research, "value" meant simply a low price compared to book value. In contrast, the CRSP indices used by Vanguard define "value" by book to price plus four other metrics: forward earnings, historic earnings, price-to-dividend, and price-to-sales. Similarly, the MSCI benchmark for "Enhanced Value" uses book to price plus two more considerations: forward earnings and the ratio of a company's entire economic value to the cash it produces. Whether these divergences from the academic standards matter, favorably or unfavorably, is not the point. For investors, "value" in a fund's name simply cannot be taken at face value. To know what you are getting, you have to read the fine print.
The chart at the beginning of this post nicely illustrates these points. The combination of small value (as defined by Wilshire) has outperformed the total market since 1980. However, for the first 20 years of that period, small value stocks under-performed, largely because they were swamped by the dot-com bubble that peaked in early 2000. Not until the bottom of the 2008-2009 recession did they regain the upper hand.