Small-Caps Do Better

Boring title isn't it? I wanted to avoid the overused title "Size Matters" which for some reason is used as a headline for topics ranging anywhere from mp3 players to water-buffalo mating rituals.

Nevertheless, the relevance of this assessment can't be dismissed. Stocks with lower market capitalizations have been found to perform better than their indexes, originally coined the "size effect" by Wolf Banz. Furthermore, in a dissertation by John J. Schmitz (now a portfolio manager at SciVest), it is demonstrated that the "size effect" cannot be explained even with multivariate factor models.

In the face of evidence suggesting the markets are not efficient, proponents of Efficient Markets Hypothesis (EMH) have never backed down before, would you expect them to now? Hardly! A flurry of papers contradicting the notion of a "size effect" have been published. Notably,

• Chan, Chen and Hsieh (1985) find that from 1958 to 1977, the Ross APT model explains away size effects
• Chan and Chen (1991) find that small firms tend to have lower efficiency and higher financial leverage
• Several articles maintain that smaller companies tend to be less diversified and more risky than larger companies (recall that EMH suggests you can achieve higher returns than the market, but that you can only do it by taking on more risk)
  

The problem value investors have with the EMH arguments has to do with the definition of risk. Value investors don't see risk as being equal to price volatility. If you do your homework: understand your company, its industry, and its financial position, you will be positioned to find companies that have low risk and that are trading at discounts to their intrinsic value. If you don't believe me, consider the returns of value investors including Warren Buffett.

Volatility is not risk! Volatility is good: it allows you to find companies trading below their intrinsic value.