By: Frank Armstrong
By: Frank Armstrong, CFP, AIF
Long-term data reveals a meaningful small and value premium. Academics take these premiums for granted. Accordingly, we overweight our portfolio to capture the extra returns. But, many investors worry that the premium is simply the result of mis-pricing and if so, it might vanish when investors discover the pricing error. Investors might collectively bid up the pricing of small and value stocks in pursuit of higher potential profits. The corollary concern is that a portfolio over-weighted in small and/or value stocks will endure additional risks for no additional reward.
I don’t believe that there is much chance of that, at least in the long run. There are fundamental economic reasons to explain the premium, and to expect that it will endure. Both the small and value premiums may be related to the company’s cost of capital. Whether a company borrows money from a bank, issues bonds to the public, or issues stocks, small companies and those that are in financial distress will have to pay more.
The flip side of cost of capital is the investor’s (lender’s) return. Faced with a choice of investing in a well-run, large company versus a distressed or small company, investors will naturally prefer the large successful company. Riskier and smaller companies have always had to pay more for capital.
The only way the market can sort this out so that everybody gets the access to capital is through the price mechanism. The price of small or distressed companies is pushed down to the point where the future return expectation for them is high enough to reward investors willing to hold them. It’s very unlikely that investors will ever prefer lower returns (or even equal returns) for small companies or distressed companies than they could enjoy from large successful companies. So, it’s logical to expect that the premium will endure. However, It is not logical to expect that the premium will appear like magic each and every period. There is too much market noise to predict anything like that. In fact, these premiums are remarkably fickle. You could have gone for very long periods in the past without being rewarded for a small or value position. Betting on the premium carries its own risks.
If the small and distress premiums had no separate risk, normal arbitrage would certainly make it disappear. We could simply sell the large growth companies short, and use the proceeds to purchase small and distressed companies. The result would be a risk free profit. We know that no such arbitrage opportunity exists; therefore, this should be abundant proof that there is a distinct risk to small and distressed companies
In a properly designed portfolio, some of these additional risks can be diversified away. If investors measure risk by standard deviation at the portfolio level as suggested by Modern Portfolio Theory, they can reasonably hope to capture some of these extra returns without enduring greatly increased volatility.
In short, because there is a measurable risk over and above normal market risk, investors will demand additional return for bearing the risk.