Factored In?

William Ehart

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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2 years ago

A great read Bill, thanks. Being of same age this is directly applicable to me and my situation. In real-life terms, from a modeling perspective and in what I think may be applicable to a broad swath of readers, I started saving/investing from essentially zero in the late 80’s, when I entered the workforce. When discussing investment growth over these time intervals (10, 20 years), the impact of compounding and reinvestment has an increasingly outsized impact. So bets made early on in an investing career, when the amounts are still relatively low, have a different impact than later, when appreciated (hopefully) portfolios are exposed to a high-growth environment, such as in this large cap/tech growth era. I need to look back at the historical basis advocating for long-term small cap growth, as it always seemed a bit suspect to me. Thanks again.

Langston Holland
Langston Holland
2 years ago

Great article on the benefits of total stock market index funds! 🙂

It does seem that small value and ex-US stocks are due for a run, but that’s the gambler’s fallacy talking. Then again, it’s difficult to believe that these “factors” are no better correlated to the past than a coin flip. 🙂

A recent small value article from my favorite Morningstar writer has some nice insights.

Roboticus Aquarius
Roboticus Aquarius
2 years ago

My take away from all this is that the market tends to move in cycles. Some of that is due to business cycles, some of it is due to decades-long economic cycles, and some of it is due to our own herd instinct. I don’t trust factor math. Anyways, it’s unlikely that I can predict if value or growth wins in the long run, so I don’t try.

Total Stock Market funds avoid the issue entirely, and are a great option.

I do think that value and growth tend to dominate for years at a time, so if one is so inclined, it’s possible to tilt back and forth to take advantage of momentum. However, the long term benefit of this is modest at best, and one also has to decide how much additional risk they are willing to take. Most of us have difficulty identifying risk, let alone knowing how much we are willing to build into our portfolio.

2 years ago

Thinking the small cap value premium is dead because the class has underperformed since 2016 is classic recency bias.

Peter Blanchette
Peter Blanchette
2 years ago

There are 3 ways to invest for long term goals. #1 is by assessing the long term market environment to determine a strategy of investing that takes advantage of those economic, political and societal factors that you determine will be the dominant ones over the investing period of time. #2 is to use the John Bogle approach. #3 is to cull the opinions of market pundits, colleagues at work and the very voluminous year by by year history of stocks, bonds, mutual funds etc. #1 is quite difficult and #3 is a very dangerous way to go I believe. For most people #2 is the way to go I believe. I have done #1 and now I am doing #2.

I started seriously investing for retirement in the mid 80’s as you did. At the time the environment was that there was a level of interest rates that can only be imagined now. It seemed that all of the forces of government was engaged in lowering interest rates in the country.I felt at the time that you should not fight the Fed as they say now. The majority of my investments were in purchases of individual long term govt bonds with a smaller portion in equities. The result was that I always slept very well. I have never had more than 30-40% in equities, usually much less. I knew that government was going to do everything it could to reduce inflation by raising interest rates. My strategy was to push money into buying as many 10 & 30 yr govt bonds as I could and just collect the interest. After a period of time the preferred strategy is now to reduce sequence of return risk by lowering level of equities and to use indexing(#2) when the future becomes unclear, which I am unable to predict confidently at this point.

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