Small Cap Value vs Large Cap Growth

In case you missed this last holiday weekend (I did), Mark Hulbert’s article in last Sunday’s NYT is worth reviewing:  Why small-capitalization value stocks tend to beat large-cap growth stocks over time.

Many theorists find this result to be somewhat anomalous, and of course, it should drive the efficient market folks insane.

Robert D. Arnott, editor of the Financial Analysts Journal and chairman of Research Affiliates, came up with a possible explanation:

"By definition, an overvalued stock has a larger market capitalization than would otherwise be the case. Its price-to-book ratio is also higher, and thus it is closer to the growth end of the growth-value spectrum. Portfolios of large growth stocks will contain a disproportionate number of overvalued issues, and should, on average, lag behind the market.

The opposite is the case for undervalued stocks. So small-cap value portfolios will have more than their share of them and should beat the market in the long term."

That’s a strictly logic based deduction, and has significance for the 1990’s ascension of market cap weighted indices, i.e., the S&P500.

"Notice that this argument does not depend on anyone being
able to identify the particular undervalued or overvalued companies.
Nor does it depend on a specific definition of fair value. All that is
required is that some stocks are overvalued and some undervalued. Only
the most diehard believer in market efficiency would deny this

In addition to showing that investors should favor small-cap and value
stocks, this new research also suggests that index funds could improve
long-term performance by changing the ways they divide their assets.
Currently, almost all index funds use an allocation method known as cap
weighting, in which a stock’s weight in an index is a function of its
market capitalization. The Standard & Poor’s 500-stock index, for
example, uses such a system."

Over the past 15 years, an equal-weighted 500 index outperformed the cap-weighted version by 1.3 percentage points a year. There are several equal weighted cap funds, most notably the Rydex S&P Equal Weight ETF (RSP)

The one caveat:  Initial conditions are key within any subsequent
comparos. So I’d like to see what this chart looks like starting in
different eras:  40s, 50s, 60s, etc. That would remove any potential
bias built in starting post ’29 crash. >

click for larger chart


Chart courtesy NYT


A Stock Market Riddle May Have an Easy Answer
NYT,  July 3, 2005

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What's been said:

Discussions found on the web:
  1. spencer commented on Jul 10

    I would still like to see a comparison of earnings growth of the the two sectors over this time period.

    It is logical that small cap would have stronger growth,
    but I have never seen data that makes the long run comparisons.

  2. None of Your Business commented on Jul 10

    Small Cap Value vs Large Cap Growth

    I’m reading a great book right now and chapter seven deals with the phenomenon of Small Cap Value vs Large Cap Growth that was posted via The Big Picture via the New York Times the other day. When you sit down and do the statistical number crunching u…

  3. dsquared commented on Jul 11

    I seem to remember that there was a working paper on this subject floating round the bowels of the LBS a few years ago. The point of that paper being that because of this very effect, “weakened” versions of the efficient market theory like Fisher Black’s in which a market is “efficient” as long as the misvaluations are not too big, aren’t sustainable. Unless the market is always valuing stocks correctly every single day, there will be market cap anomalies from which profits can be made. Market efficiency is a much more restrictive condition than its advocates believe it to be.

  4. royce commented on Jul 11

    Market efficiency also values stocks based on what is known about them plus speculation of what those companies and customers will do in the future. There’s bound to be less known about small companies than there is about large caps. valuations of small caps, and the markets they create or serve, are going to have a greater predictive errors than the more stable big caps.

    Efficient markets theory doesn’t mean perfect accuracy. It just means best possible accuracy.

  5. Willos commented on Aug 18

    I just don’t see why the conversation about the article has to do with Black’s model. The large cap/small cap are result of the financial worth of the company + premium based on the growth that the market expects from these companies.

    Black’s model is for pricing derivatives and it is independent of the expected return of the stock or the cap size of the company. Market efficiency is assumed for derivative not the pricing on a stock.

    How you price a stock is really more subjective than objective. The market is only efficient in putting the expectations of the market into the price of the stock.

  6. Michael Steele commented on Dec 8

    Small Cap Value has a good record against Large Cap Growth, but now (12/8/07) may be one of those times when the tables are reversed. In periods where the VIX is high and the CBOE Put/Call ratio is high — Large Cap Growth does its best against Small Cap Value, perhaps as much better as an 8% spread, if past is prologue to the future.

  7. Retirement investment advisor commented on Mar 2

    My own research shows that in any given year, the odd of small cap value outperforming large cap growth is about 3/4. In any given 10 years though, the odd of that is about 5%. In any given 20 year period in history, there has never been a single period when small cap value underperformed large cap growth. Here is the partial result of the study of small cap value performance.

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