Before you jump to the conclusion that you should avoid small stocks, which is what some investors were doing, let’s take a closer look at the explanations. We’re going to take a closer look at each of these claims, beginning by examining the claim that it’s getting harder for small stocks to grow and migrate into a large stock.
The investment and growth opportunity set of small companies is shrinking, and their nimbleness and grit is increasingly under pressure. In contrast, the large companies are thriving, investing in innovation and intangible assets at an increasing pace, and seem better prepared to weather challenges from small companies than portrayed in literature.
MigrationDimensional Fund Advisors (DFA) has data on size migration from June 1963 through June 2018 (the original HBR article covered the period 1980 through 2017). In reviewing the DFA data I found that the percentage annual average migration from large to small was 1.4 percent. It actually increased slightly to 1.6 percent in the more recent period beginning in June 2000—slightly more large companies were becoming small companies than was historically the case. In terms of the percentage of small companies migrating into large companies, the full period percentage was 9.1 percent. Over the more recent period beginning in June 2000, the percentage did decrease, though only slightly to 8.9 percent. Overall, there doesn’t seem to be any significant change in migration patterns. The conclusion you should draw is that the proportion of stocks that migrate varies over time and is not predictable from one period to the next. Next, we turn to the question of profitability.
ProfitabilityAs the authors of the HBR study noted, the profitability gap between large and small companies in the U.S. has widened dramatically over the past 25 years. Before we dig deeper, note that this is mainly attributable to recent growth in profitability for U.S. large caps. As my co-author, Andrew Berkin and I note in “Your Complete Guide to Factor-Based Investing”, before drawing any conclusions from data you want to make sure that the findings are not only persistent but pervasive around the globe. Otherwise, the result might be a purely random outcome or the result of a data-mining exercise. Data from Dimensional shows that the weighted average profitability of large companies in the developed countries ex-U.S. was virtually unchanged over the period from June 1990 through June 2019, and it had slightly declined for large companies in the emerging markets. Thus, we can conclude that there is no global pattern of increasing large company profitability. We turn now to the issue of R&D spending.
Research and Development SpendingA third claim of the paper is that large companies are increasingly likely to maintain their dominant positions over small companies. The authors conclude that the primary reason for this is the widening gap in R&D expenses between large and small companies. For example, the authors state that the average large company spent $330 million on R&D in 2017, while the average small company spent only $6 million. It’s not surprising to observe large companies spending more on R&D in absolute dollar terms than small companies. A more meaningful assessment is to examine historical R&D expenses relative to operating expenses 1. Dimensional has data going back to July 1974. Examining the data, they found that the R&D-to-operating expense ratio indicates that, in aggregate, large and small caps have spent a similar fraction of their total operating expenses on R&D. We can also look at the global data on the investment performance of small and large caps.
Equity ReturnsThe data below looks at the annualized returns over the 20-year period ending September 2019.
- U.S. Large (CRSP 1-5) 6.6 percent versus U.S. Small (CRSP 6-10) 9.2 percent.
- MSCI EAFE Index 4.2 percent versus MSCI EAFE Small Cap Index 7.4 percent.
- MSCI Emerging Markets Index 7.6 percent versus MSCI Emerging Markets Small Index 7.4 percent.
ConclusionsThe bottom line is that there doesn’t seem to be sufficient evidence for investors to consider abandoning the hypothesis that small companies should outperform over the long term as the evidence of a size premium is persistent, pervasive, and intuitive. (see here for a piece by Wes that covers the debate). And with the dramatic decline in trading costs, it’s also an implementable strategy, especially for those that engage in patient trading, providing, instead of demanding, liquidity. In addition, the correlation of the size premium to the market beta premium has historically been relatively low at about 0.2. Thus, adding exposure to the size factor not only provides exposure to an expected premium, but it also provides diversification benefits.
- Operating Expenses are defined as cost of goods sold plus selling, general, and administrative expenses plus interest expense ↩