In the late 1990s, the ink was barely dry on Fama and French's investigations into the small-cap value equity premium when it looked like the research was crashing and burning. If any corner of the stock market was likely to offer a premium over equities generally, large growth companies looked like obvious candidates, thanks to their soaring prices at the time. The premium in small-cap value, meanwhile, was missing in action.
Or so it seemed until mid-2000, when the great bull market in equities started coming apart. Small-cap value was an exception. Instead of crumbling, it posted a tidy advance in the otherwise ferocious bear market of 2000-2002.
It was the first test of the Fama-French three-factor model (FF3) over a full business cycle since the research was published, and the results looked impressive. Perhaps the small-cap-value premium would be worthy of its own allocation, just as the research by Fama and French implied. If so, investors would need to consider these equities as a distinct beta from the broad stock market.
For some, the counsel is self-evident, given the research and the subsequent track record logged by small-cap value stocks over the decades. Nonetheless, the idea remains controversial 17 years after the first of several FF3 papers formally identified the concept.
Like most notions in financial economics, FF3 is continually debated, tested, retested and then questioned anew. No wonder, then, that the consensus is as elusive as ever that small companies trading at deep discounts to book value are effectively a separate asset class. The idea may be destined for eternal debate, but after nearly two decades of discussion and research, one might wonder: What, if anything, have we learned?
Quite a bit, it turns out. What's more, the lessons are especially timely now, in the middle of the worst recession since the Great Depression.
Let's start with a brief review of the economic logic behind FF3 and why one particular slice of the stock market-and a rather small one at that-should carry so much relevance for managing equity allocations. The answer lies in the finer points of risk, of which small-cap value harbors an outsized helping for its puny market cap.
The reason is that small companies trading at low multiples to book value and other fundamental measures tend to be distressed firms, even in the best of times. During the dark side of the business cycle, small-cap value stocks are clearly the poster children for vulnerable companies. Think of them as the antithesis to blue chips. Expecting small-cap value to bear the brunt of a recession, investors are inclined to abandon the stocks in search of safer terrain. When the outlook improves, sentiment changes and the market breathes a sigh of relief, giving the sector a renewed aura of possibility.
Because investors shun the weakest in times of high economic stress, it's expected that small-cap value would generate a risk premium over the stock market generally. These stocks, in the language of financial economics, have a higher covariance with the business cycle than stocks overall. In that sense, we can think of small-cap value as a recession beta-a beta that's expected to generate a return premium above and beyond what's dispensed by a passive measure of stocks generally.
This perspective gains more support when we review how these equities fared against the broad market-cap-based measure of stocks following recent recessions. Figure 1 shows the return difference for the Russell 2000 Value Index (a small-cap value benchmark of U.S. stocks) less the performance of the Russell 1000 (large-cap U.S. stocks). Following the end of the three previous recessions (as defined by the National Bureau of Economic Research), small-cap value earned substantially higher returns against the broad market. For instance, in the 12 months after the 1981-1982 recession that ended in November 1982, the Russell 2000 Value gained 41% while the Russell 1000 earned 25.1%-a return premium of 15.9% in favor of small-cap value.
Far more encouraging is the fact that the small-cap premium holds up over longer periods. For the 80 years through last year's close, small-cap value posted an annualized total return of 13.4%, based on the Fama-French data series as published in the Ibbotson 2009 Classic Yearbook. That's comfortably above the 9.6% return for large-cap stocks (based on the S&P 500) over those decades as well as other major style and capitalization subcategories of U.S. equities. The small-cap-value premium also remains intact through time in many foreign markets in the developed world, several studies have shown.
Small-cap value's history is even more compelling when we consider research published over the last 20 years demonstrating that business cycles are partially predictable. If we know that small-cap value generates a premium in the long run, and that the premium is linked to the risk inherent in the business cycle, clues about the odds of future recessions and economic rebounds are particularly valuable. It's also timely in 2009, given the current recession.
To understand why, let's review research suggesting that the yield curve is a useful measure for predicting business cycles. In the late 1980s and early 1990s, a new generation of studies appeared finding that the inversion of the Treasury yield curve (short rates above long rates) was a sign of an approaching recession. Normally, the yield curve is upward sloping, meaning that longer maturities command higher yields. This is the normal state of affairs for the bond market. Economic logic suggests that longer holding periods incur higher risk, so investors should be compensated with higher yields.
One 1991 Journal of Finance study was an early effort in academia at demonstrating that the yield curve offers practical information about the timing of the business cycle (it was called "The Term Structure as a Predictor of Real Economic Activity," by A. Estrella and G. Hardouvelis). The main point is that the curve tends to be downward sloping (with short yields over long yields) when it is at or near the onset of a cyclical downturn. During recessions, the curve is upward sloping (short yields below long yields).
This offers a rationale for anticipating a positive relationship between the shape of the curve and the future equity risk premium. A 1989 research paper by Fama and French, for instance, notes that expected stock market returns are higher in recessions than they are amid forecasts during economic expansion ("Business Conditions and Expected Returns on Stocks and Bonds," Journal of Financial Economics, 1989).