Is the Small Firm Effect Over?

It’s a concept in investing that is so widely known now that it might almost be a truism:  Smaller companies will provide better investment returns over time than larger companies.  But how did we come to believe that?  More importantly, do more recent investment returns suggest that this “small firm effect” has disappeared?

First, the history of the concept.  In the mid-1960s, four financial economists, working independently, came up with the Capital Asset Pricing Model, or CAPM.  Simplified a bit, CAPM states that the expected rate of growth of an asset depends on the relative amount of risk inherent in that asset.  If a specific stock is riskier than the market in general, investors will demand a higher return in exchange for exposing themselves to that risk.

Subsequent research found that the CAPM model explained about 70% of the variability in investment returns, so other researchers were motivated to look for improvements to the model.  To date, Eugene Fama and Kenneth French have contributed the most significant improvement.  Their Fama-French Three-Factor Model, released in 1992, explained about 90% of the variability in investment returns.  It added two factors to the CAPM model:  the out-performance of small-capitalization companies over large-capitalization companies, and the out-performance of high book-to-market ratio companies over low book-to-market ratio companies.  (No more about book-to-market here, though that is interesting stuff as well.)

In their original research, Fama and French did not attempt to explain why small companies might outperform large companies over time.  Most commenters who have taken a stab at answering that question have gravitated towards the potential for greater relative growth as the best explanation.  Put simply, a company that is already worth $100 billion won’t see its stock price go up that much if it develops a new product that adds $1 billion in sales annually.  If a company worth $1 billion developed the same product, its stock would be expected to soar.

Here’s the information that got me questioning whether the small company effect persists today:  From the stock market’s peak before the Great Recession, in October 2007, through March 2019, large-cap blend stocks had an average compound return of 2.41%.  Over the same period, small-cap blend stocks had an average compound return of 1.12%.  Both returns numbers are pretty anemic, but the fact that large company stocks outperformed small company stocks by about 1.3% annually over a period of 11.5 years is, at the very least, interesting.  And that is despite small company stocks being significantly more volatile than large company stocks over the last ten years; remember, from the very top, that investors are supposed to demand higher returns from riskier assets.

Expanding the time horizon considered can flip things around.  From 1998 through 2017, small company stocks outperformed large company stocks by 2.8% annually (10.0% average compound returns for small company stocks versus 7.2% for large company stocks).  And over the even longer term, from 1926 through 2017, small stocks outperformed by 1.9% annually.

So, where does all this information leave us?  If the small company effect persists, then, it’s fair to say, we are overdue for small company stocks to start outperforming large company stocks. It’s also possible that there’s been a fundamental shift in the way that markets work—for example, the instantaneous availability of information about all companies, large and small, that the web makes possible—that has eroded or canceled the small company effect that Fama and French detected in the early 1990s.  Dedicating some allocation to small company stocks still makes sense for most investors for purposes of diversification and risk reduction regardless of the small company effect—but it would certainly be nice if owning those stocks once again rewarded investors with higher returns.


Sources:  “2018 Fundamental for Investors,” Morningstar.  “Small Firm Effect,” Investopedia (updated May 28, 2019).  J.P. Morgan Guide to the Markets (March 31, 2019).


Any opinions are those of Scott Boatwright and not necessarily those of Raymond James. Expressions of opinion are as of this date and are subject to change without notice. There is no guarantee that these statements, opinions or forecasts provided herein will prove to be correct. Investing involves risk and you may incur a profit or less regardless of strategy selected. Keep in mind that individuals cannot invest directly in any index, and index performance does not include transaction costs or other fees, which will affect actual investment performance. Individual investor’s results will vary. Past performance does not guarantee future results. Future investment performance cannot be guaranteed, investment yields will fluctuate with market conditions. Investing in small cap stocks generally involves greater risks, and therefore, may not be appropriate for every investor.