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).

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