For decades, there has been a staple idea in the money management industry that you can earn a substantial premium from small-cap stocks over large caps. But like so many other strategies that arise from the conclusions of empirical research, this one has flaws, and the transition from paper to portfolio has been a rocky affair. And now we know why—the prevalence of financially weak companies in the small-cap space.  

A new study suggests that quite a lot of the on-again/off-again nature of the small-cap premium is due to companies suffering from financial troubles of one kind or another. The good news is that systematically dodging these firms tends to generate a stronger, more reliable small-cap premium.

“Size matters—and in a much bigger way than previously thought—but only when controlling for junk,” says the first draft of new research by AQR Capital Management’s Cliff Asness and four co-authors. The paper’s main conclusion is striking because it appears to resolve the conundrum long bedeviling small-cap strategies: extended periods when the results are less than compelling, if not downright disappointing.

By some accounts, the small-cap premium was oversold from the start and ended up as one more academic-fueled illusion that shines on paper but falls flat with real-world results. A study from a few years ago asks the question that’s on the minds of many small-cap skeptics: “Is Size Dead?” Mathijs A. Van Dijk, a finance professor at the Rotterdam School of Management, writing in The Journal of Banking and Finance in 2011, noted that “recent empirical studies assert that the size effect has disappeared after the early 1980s.”

That’s a bit harsh. An investment in small stocks (defined as the Russell 2000 index) has, in fact, beaten large caps (the Russell 1000) over the long haul. A buy-and-hold $100 investment in the Russell 2000 at the close of 1978 was worth roughly $2,896 by January 30, 2015, which is a sizable premium over the $2,137 that the same investment generated in the large-cap Russell 1000 Index, based on price-only data.

A higher return of roughly one-third is substantial, but you had to endure a rough road to earn that premium, including long stretches when small caps underperformed by a significant degree. A long view may redeem the small-cap premium as traditionally defined. As a practical matter, however, few investors can tolerate extended periods when the performance trails that of usual suspects such as the S&P 500. But maybe they don’t have to.
 
Asness and company explain that by “controlling for junk, a much stronger and more stable size premium emerges that is robust across time, including those periods where the size effect seems to fail.”

Too good to be true? Maybe, although the numbers in this study suggest otherwise. If so, it may be a new era for small caps.

A Superior Subset
“The main point of the paper is that when you look at small stocks, there’s an element within small stocks, a subset, that’s junky and a subset of higher quality,” says Ronen Israel, one of the co-authors of the AQR Capital paper (called “Size Matters”) and a principal at AQR in Greenwich, Conn. “When you control for that additional dimension—junk versus quality—you see a strong size effect,” and so “the size premium emerges as a much larger, more stable and more robust return premium.”

There are several implications for investing, including a new road map for building superior small-cap portfolios. It might also mean designing a new generation of indexes for ETFs and more properly explaining the sources of risk and return in equity strategies. But the paper’s central conclusion is that the small-cap premium is very much alive and well … if you’re looking in the right places.

But how do Asness and colleagues define junky firms? There’s no one universally accepted methodology. The authors measure each company’s financial health by taking the average of several metrics: profitability, growth, safety and payout.

But the results speak for themselves. For instance, consider the performance history for the past 20 years of three buy-and-hold strategies targeting low-, medium-, and high-quality U.S. small-cap stocks. As Figure 1 shows, the high-quality strategy dramatically outperformed the portfolios formed on lesser-quality equities. A $100 investment at the close of 1994 rose to more than $1,000 by the end of last year—well above the roughly $640 in the medium-quality portfolio and the $172 found in low-quality small caps (based on risk premiums calculated by AQR).

An Old Idea That’s New Again
The question, of course, is whether the results are just data mining and therefore destined to end up as another asset-pricing anomaly that stumbles as an actual portfolio. The answer to that might lie with the father of modern securities analysis and value investing’s original guru: Ben Graham.

The strategy of buying undervalued stocks is enshrined in the classic book Security Analysis, which Graham and co-author David Dodd published in 1934. If you read this iconic text, which inspired several generations of money managers, you’ll also notice an emphasis on value and quality.

Graham continued to focus on these two aspects of stock selection through the years. In his best seller geared for the general public, The Intelligent Investor, he reminded readers that “a stock does not become a sound investment merely because it can be bought at close to its asset value.” The qualitative factor must be considered too, he added, recommending that “the investor should demand … a satisfactory ratio of earnings to price, a sufficiently strong financial position and the prospect that its earnings will at least be maintained over the years.”

Or as Warren Buffett—Graham’s most-famous and successful disciple—reportedly explained some years ago: “I try to buy stock in businesses that are so wonderful that an idiot can run them. Because sooner or later, one will.”

The ability to avoid the idiots, so to speak, is an honored skill in investing, and it’s especially crucial in the realm of small caps, according to Asness and co-authors. That’s hardly surprising, or at least it shouldn’t be. As “Size Matters” explains, large companies “tend to be high quality firms … while small firms tend to be ‘junky.’” That’s a reminder that filtering out the low-quality stocks among small caps is essential to reliably capturing the premium associated with them.

Yes, But …
The case for quality small caps suggests that there might be a major rethink about indexing in this market niche. A no-brainer, right? Not so fast, says Joel Dickson, global head of investment research and development at Vanguard. “It’s just another strategy,” he says. In fact, it’s one that’s already in use to a degree at his firm. “At Vanguard, we have some quant funds that incorporate quality approaches into their selection of securities.”

In any case, Dickson doesn’t see it as a game-changer for rewiring small-cap indexing. “Once you say we can outperform traditional small-cap indexes, then it’s active risk.” In turn, that opens the door for higher turnover and higher fees than you’d find in plain-vanilla passive products.

Fair enough, but it’s going to be hard to put this genie back in the bottle, says Phil DeMuth at Conservative Wealth Management in Los Angeles. “It’s just a question of time before they integrate it,” predicts DeMuth, author of the book The Affluent Investor and other titles. After reading the paper, he thinks that there’s opportunity for enhancing the choices in the small-cap arena with a new line of products. “AQR will probably be first on the block; Dimensional [Fund Advisors], too, eventually. They’ll all end up using quality plus small cap going forward.”

There may be some disruption coming to the small-cap-value realm too. The “Size Matters” paper doesn’t invalidate the value research that’s been widely embraced over the years. But the paper sheds a bit more light on why expected returns are comparatively high in this corner of the equity market.

“If you combine value and quality, you’d have a stronger portfolio than if you just look at value on a stand-alone basis,” says AQR’s Israel. “Quality helps to hone in on the cheap stocks that are cheap for a good reason.”

As for the high-quality small caps that fit the bill, the choices are still generally determined by the subjective views of active managers and perhaps a handful of so-called smart-beta products.

With index funds, it depends. Consider, for instance, the iShares Core S&P Small-Cap, an ETF that hugs the S&P SmallCap 600, and the iShares Russell 2000, which tracks the Russell 2000. According to AQR’s figures, the former is more exposed to high-quality small-cap names. When we run the two ETFs through a multi-factor-analysis grinder, we see that not all index funds are created equal when it comes to grabbing a piece of the high-quality small caps. Analyzing the funds through the prism of AQR’s figures reveals that the S&P-based fund’s beta for high-quality small caps was roughly 0.60 while the Russell fund’s was 0.34.

Does the difference explain why the former outperformed the latter by a healthy margin over the past five years? There are no absolutes in asset pricing, but given the historical record in the “Size Matters” paper, it would be surprising if the answer wasn’t closely linked with the high-quality small-cap factor.