Factored In?

William Ehart  |  November 5, 2020

WELL, IT SOUNDED good. Academic theory and nearly a century of investment experience supported the argument that small-cap value is the most promising market segment over the long term, since it offers the superior risk-adjusted return that comes with owning both neglected small-cap shares and shunned value stocks.

But as legendary economist John Maynard Keynes observed, in the long run, we are all dead. In my 36-year investment career, both small- and large-cap value have lagged large-cap growth. Fortunately, I have 10 more working years left, and I haven’t given up on small, mundane companies.

You can get any result you want by cherry-picking time periods. But we don’t get to choose when we’re born. Come of age at the wrong time and you might rue the day you read about Eugene Fama and Kenneth French.

The two finance professors analyzed stock returns since 1926. They developed a “factor” model in 1992, providing the rationale for why small-cap value should perform best long term, followed by large value, large growth and small growth, in that order.

But how relevant is data from the mid-20th century? Further, small-cap outperformance can be isolated to a few relatively short periods, such as the mid-1970s to mid-1980s. From Dec. 31, 1974, through Oct. 31, 1984, small-cap value compounded at a 30.2% annual rate, compared with 22.8% for small-cap growth, 18.4% for large-cap value and 12.5% for large-cap growth, according to Yet, before the 1980s, it would have been prohibitive to build a diversified portfolio of small-cap value stocks, as Ben Carlson noted recently in his excellent blog.

Our own investing lifetimes are what’s relevant to us. I graduated from college in 1984. Let’s say that, by Oct. 31 of that year, I was able to start investing in earnest and I bet on small-cap value. Meanwhile, my cousin Mike went for large growth companies.

Sure enough, through 2016, I would have looked like a genius, even though I got into small value after an historic run. As you can see in the accompanying chart, an initial investment of $10,000 on Oct. 31, 1984, would have been worth nearly $180,000 more than Mike’s large-cap growth stake.

The lousy performance of small growth companies from late 1984 through 2016 also seemed to validate the Fama-French model: They combine the riskiness of unproven companies with the inflated expectations of growth stocks. On the other hand, contrary to Fama-French, large value lagged large growth.

But hypothetical me, gloating about my small-cap value victory, started picking out retirement homes in Boca too soon. That’s because small-cap value has been a disaster since 2016.

Over the whole period, from Oct. 31, 1984, to the present, Mike would be way, way ahead on his $10,000 initial investment. I would barely have any more money than in 2016, while Mike would have over $300,000 more than he had.

What does this prove? It shows that factor bets can be incredibly lucrative but also hazardous to our wealth. We have to avoid blind adherence to investment rationales just because they sound good. But having chosen to emphasize a factor, we should avoid giving up after a period of weakness.

In my real life, I’ve been in and out of small-cap value since the 1990s, which reflects poorly on me as an investor. But the superior return potential of small-cap value still makes intuitive sense to me. I hope to retire in 10 years. Obviously, that’s too short a period to bet heavily on any one asset class. But it’s not too short to wager modestly on a factor rebound or on reversion to the mean.

I’ve put a few more chips on small-cap value stocks, for myself and my family, since they plunged in March, as I mentioned here and here, and I added a little more in October. I have a good rationale for this (there’s that word again).

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First of all, small value historically has rocked after a period of irrational exuberance for large growth, as it did in the 1970s after the Nifty Fifty craze and in 2000-02, as the dot-com bust unfolded. Today, the valuation gap of large growth over small value is again at an extreme, as O’Shaughnessy Asset Management and others have noted. Second, small-cap value tends to lead coming out of a bear market. That said, it hasn’t led since this year’s March 23 market bottom, as shown in the chart. (For what it’s worth, small-caps were positive in October while the overall market fell.)

Nearly 12% of my stock portfolio is in dedicated U.S. and foreign small-cap value funds. That’s a hefty satellite position, and my only factor bet. It’s enough to make a meaningful impact on my returns if undervalued small companies outperform again, but not so much to make me a complete fool if they don’t. Would I be greedy if I bet a bit more?

Maybe by the time I retire, small-cap value will be on top again, and all will be right with the world and the Fama-French model.

In which case, Mike will be welcome in Boca.

William Ehart is a journalist in the Washington, D.C., area. Bill’s previous articles include Shooting StarsDifferent Strokes and Needing to Know. In his spare time, he enjoys writing for beginning and intermediate investors on why they should invest and how simple it can be, despite all the financial noise. Follow Bill on Twitter @BillEhart.

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