Recently I read an excellent Cliff Asness (AQR founder) paper Size Matters, if you Control your Junk.  It is very comprehensive research on the size effect. Highly recommended.

First popularized by Fama & French, the size effect says small companies outperform large by a few percentage points per annum.

After Fama & French, the size effect got a lot of criticism from new empirical research however for not being statistically significant or being the result of data mining. The main pain points that make the size effect appear less statistically significant – than for example value or momentum – are basically:

  • small caps do not outperform consistently
    • over time (in the ’80-’00 period they underperformed)
    • globally
    • over certain stock characteristics (value vs growth, positive vs negative momentum)
  • small caps outperformance seem to be concentrated in
    • January
    • illiquid stocks
    • the most extreme size deciles (smallest companies and largest companies): the size effect does not exhibit “monotonicity”. In other words, the best performing decile might be the smallest companies’ decile, but the remaining deciles do not have monotonically decreasing returns toward the last decile

The authors then surgically show that all these criticisms are trumped by the size effect if you control for “quality” (defined by high profit margin, low leverage, high sales growth, good quality of earnings). In other words, small caps have not significantly outperformed globally, over time, over certain stock characteristics, in Feb to Dec, etc. because stocks in the smaller company universe tend to be more “junky”.

If you buy small companies that are on average as high quality as large companies, you actually get size outperformance that is consistent over all the above metrics (time, geographically, value and growth, liquidity, all year) and  the effect becomes monotonically decreasing with the size decile.

Now that we can rest assured the size effect is significant and robust over all these variables when we make an apples-to-apples comparison with large stocks in terms of quality, the cherry on top is that the value effect much larger in small caps. This great paper shows how much.