Decades of academic research have identified that there are systematic differences in expected returns based on what is commonly referred to as factors. We can exploit these factors to structure portfolios to target higher expected returns. An example is the small cap premium.
Persistent and Pervasive Factors
While there is no guarantee that these factors will continue to out-perform over time, empirical evidence has suggested that these factors have been persistent (i.e., occurred over time) and pervasive (i.e., occurred over the equity markets in various geographical regions).
4 “Premiums” of Return
Over the next several weeks, we are discussing the four factors that have been shown to be persistent and pervasive. These factors give rise to “premiums” of return. These premiums are:
- Equity premium
- Small cap premium
- Value premium
- Profitability premium
To be considered a dimension of expected return, a premium must be all of the following:
This week: The Small Cap Premium
This week we are going to take on the small cap premium. The small cap premium is based on empirical evidence (i.e., data) that suggests smaller companies will outperform larger companies.
The small cap premium – applying the basics of mathematics
To help understand why this makes sense intuitively, let’s consider Apple:
- Market capitalization represents the value of the companies in a particular market. Essentially, you add up the total of the number of shares of each company when multiplied by their current price. For US based companies, that’s around $30 TRILLION dollars.
- Apple has a market capitalization of around $1 TRILLION dollars
- That means that Apple’s “value” (as expressed by market capitalization) is a bit over 3% of the total value of the US market.
PUNCHLINE – Apple may want to “take over the world,” but it’s going to be difficult to do so given the above numbers!
Smaller companies only have to make smaller ABSOLUTE increases to achieve larger PERCENT increases.
The small cap premium is really nothing more than a restatement of a mathematical fact: to get an equal percentage increase a larger number will require a larger ABSOLUTE increase than a smaller number. 10% of 1 trillion is $100 billion. 10% of $100M is $10M. Smaller companies only have to make smaller ABSOLUTE increases to achieve larger PERCENT increases. It’s math folks!
The small cap premium – both persistent and pervasive
The small cap premium has been shown to be persistent and pervasive. For that reason, a portfolio that “over weights” or “leans” into smaller capitalization companies has been shown to have a higher expected return over the long run.
In upcoming weeks, the other 2 premiums
In the following weeks, we will go through the value and profitability premiums. Each of these premiums will also have a logical, easy to understand explanation that backs up what the academics have found. For this reason, I have a high degree of confidence in using a factor- based approach to investing, which is built on leveraging these premiums.
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