One of the oldest and most persuasive arguments in the stock market is that small stocks outperform large stocks. 1 Warren Buffett, speaking at the 2013 Berkshire Hathaway Annual Meeting, summarized the sentiment when discussing the disadvantages of managing a huge amount of capital:
size effect, after properly controlling for data issues, liquidity concerns, and proper adjustments for risk. In short, perhaps Banz’s size effect never really existed! To many investors, who invest in products focused on small-cap stocks, this will surely come as a not-so-welcome surprise. (below is a chart from the paper that summarizes much of the analysis).
The implication is that managing a huge asset base prevents an investor from exploring the more intriguing opportunities available in smaller and more illiquid stocks. 2 We agree with Buffett: having a fat wallet makes it tough to outperform. If investors are focused on long-term outperformance, small stocks are a good place to find outsized returns. Of course, you still need a solid underlying investment process – small stocks won’t cure bad ideas. But coupling a reasonable process with smaller stocks can be a wonderful approach. For example, almost all popular investment factors, including value and momentum, have historically worked much better in smaller stocks than they do in mega-cap stocks. And while Warren Buffett’s quote seems to suggest that the debate over the outsized potential of small caps is settled, it turns out there is substantial debate on the topic. Investors looking to make more informed portfolio decisions should be aware of these arguments before grasping small caps with both hands.
There’s no question size is an anchor to performance.