Small Cap Effect: “It’s Only a Flesh Wound!”

CAPM / Alpha Theory 18 Apr 2007

Apparently it’s open season on Fama & French’s 3 factor model. Yesterday on these pages, researchers argued that the value premium was largely explained by transitional distress, not fundamental (“structural”) value. And today we receive word via John Mauldin’s weekly newsletter that Dresdner Kleinwort’s James Montier has leveled an attack on the model’s alleged small-cap outpeformance – leaving 3F proponents taunting us with cries that “it’s only a flesh wound!”.

In this week’s edition of “Outside the Box”, Montier shows how small cap did indeed outperform large cap prior to 1981. But after that time, the outperformance of small cap stocks has been negligible. He chalks this up to the fact that capitalization is a factor of stock price – and stock prices fluctuate. So the capitalization factor implicitly integrates two components: valuation and actual firm size. He cites fundamental indexation guru Rob Arnott’s research that shows the “small cap factor” is dramatically less predictive when it’s based solely on a fundamental metric like sales, as opposed to the traditional market capitalization metric. Apparently, Montier’s own research on European stocks corroborates this observation.

We note that this line of argument is similar to that pursued by the author’s of yesterday’s paper on the value-premium. In both cases, the factors are said to be heavily influenced by transitional valuation – making it difficult to determine if “small cap” and “value” actually just capture companies whose price is temporarily in the gutter.

Montier argues not only that small caps have lost their sheen over the past quarter century, but that they are currently overpriced. He points to the higher PE ratios of small caps in both the US and Europe as evidence that investors shouldn’t expect to get rich in the asset class any time soon. In fact, small cap PE ratios are now higher than large cap ratios (i.e. investors are paying a premium for “the pleasure of holding illiquid, inherently more idiosyncratically exposed, cyclical stocks”).

Montier concludes with some words of short-term warning about small caps. But his overall message is clear: the small cap factor is in trouble – and unlike Monty Python’s tenacious knight, it’s more than just a flesh wound.

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