Recent Underperformance of Small and Value Companies
Client Question of the Week:
Should I be concerned about the recent underperformance of small and value companies?
When you go through a time period like we have gone through recently where value has underperformed growth, and small caps have underperformed large caps, it's natural for people to want to question if they should change their asset allocation. However, getting past the recency bias and understanding that we want to make investment decisions based on probabilities rather than possibilities may lead to a better investment experience.
Taking a step back, we know that both the value and size premiums are rooted in sound economic theory. All else being equal, companies with lower relative prices (value stocks) and lower market capitalization (small cap stocks) should have higher expected returns. In addition to being economically sensible, these premiums are supported by a preponderance of evidence spanning nearly a century in the US and more than five decades in non-US markets.
While we wake up every day and expect positive value and size premiums, we understand there is volatility associated with pursuing these premiums. Exhibit 1 shows the percentage of 1-, 5-, 10-, 15-, and 20-Year periods with negative premiums in the US equity markets through December 31, 2019. As illustrated below, there will be times when we experience negative premiums, but as an investor, you need to determine if you want to make a decision that has a high probability or low probability of success.
Putting investing aside, imagine you’re flipping a slightly biased coin – one where, like the value-premium over 1-Year periods, you have a 60% chance of Heads and a 40% of Tails. If I promise to give you $20 if you guess correctly when I flip, what would you guess? Now let’s say that it lands on Tails, and it can happen… what would your second guess be? Still Heads, right? You wouldn’t change your answer just because the less-likely of two things happened. You’d probably still choose Heads.
We use logic and evidence to inform our decision making process every day. In a recent interview with NBA champion Shane Battier compared playing blackjack with basketball:
If you’re playing blackjack, there are certain hard and fast rules. You always double down on 11, no matter what. You always split aces. And you always hold on 17. Are you guaranteed 100% to win those hands if you do those things? No, but mathematically it’s proven that if you do that over a long period of time, your chances of success are greater than if you go against what you should do in those situations."
He went on to discuss how he applied this line of thinking to guarding Kobe Bryant:
Kobe, may he rest in peace, I knew when Kobe Bryant went to his right hand and shot a shot in the paint — and you factor in makes, misses, fouls drawn, free throws off those fouls, passes to teammates, their shots off those passes — it was a 62% shot. So every time he did that shot, it was worth 1.26 points. And when he went to his left hand and I kept him out of the paint — factoring makes, misses, fouls draw, free throws, passes, turnovers — it was only a 43% shot. So every time he went left and did that shot, it was worth 0.84 points. Now you don’t have to be a math major to know that guarding Kobe Bryant, you don’t want him to do the 62% thing. You want him to do the 43% thing.
Premiums vary significantly from year to year. The graph below illustrates the annual small cap premium from 1999 through 2019.
Despite compelling theoretical and empirical evidence supporting the premiums, investors may be tempted to extrapolate the recent past into the distant future, which can lead them to abandon their investment philosophy at potentially inopportune times. Maintaining discipline and sticking to the plan are vital. The performance of premiums in the recent past doesn’t tell you much about future premiums. So, if your goals haven’t changed, then your asset allocation likely doesn’t need to change.
Past performance is no guarantee of future results.
Percentage of rolling 1-, 5-, 10-, 15-, and 20-year periods with negative premiums is calculated using monthly return data from June 1927 to December 2019 for market, size, and value, and from July 1963 to December 2019 for profitability. Market: Fama/French Total US Market Research Index minus the One-Month US Treasury Bills. Size: Dimensional US Small Cap Index minus the S&P 500 Index. Value: Fama/French US Value Research Index minus the Fama/French US Growth Research Index. Profitability: Fama/French US High Profitability Index minus Fama/French US Low Profitability Index. Profitability is measured as operating income before depreciation and amortization minus interest expense scaled by book. One-Month US Treasury Bills is the IA SBBI US 30 Day TBill TR USD provided by Ibbotson Associates via Morningstar Direct. Dimensional Indices use CRSP and Compustat data. Indices are not available for direct investment, therefore, their performance does not reflect the expenses associated with the management of an actual portfolio.