A quick review of the literature regarding the ‘small-cap premium’

October 2017 | SPOTLIGHT | FINANCE & INVESTMENT

Financier Worldwide Magazine

October 2017 Issue

It is somewhat intuitive that small-cap stocks can be expected to generate higher returns than large-cap equities and therefore, a priori, generate greater risk. They also tend to be “more volatile and have less analyst coverage which may increase the risk of mispricing. An efficient market should compensate investors for accepting greater non-diversifiable risk with higher expected returns”, according to Morningstar. The ‘small-cap’ premium has become a ubiquitous staple in corporate finance theory and practice. For the valuation profession, this often translates, in effect, to the addition of an incremental ‘discount’ of between 3 and 5 percent in developed markets to the cost of capital as calculated through traditional models such as CAPM and WACC.

This required return ‘build-up’ would then look like this: “Cost of Equity = Risk free rate + Beta * Equity Risk Premium + Small Cap Premium”.

As the discount rate is used to estimate future cash flows, this practice, by definition, would negatively affect economic value. However, over the last few years, there has been a ‘pushback’ against the concept. The idea of this article is to provide a macro snapshot of the literature, approaches and key arguments in the space.

Academic researchers have been studying the small cap premium for more than 30 years. A 1981 paper by Rolf Banz argued that “smaller firms have had higher risk-adjusted returns, on average, than larger firms”. This performance difference has come to be known as the ‘size effect’ or the ‘small cap premium’. According to FTSE Russell, “The notion of both a small cap premium and a value premium in equity returns was solidly established with the publication of papers by Nobel Prize winner Eugene F. Fama and co-author Kenneth R. French. The Fama-French three-factor model of market, value and small cap factors has become a bedrock of academic and practitioner research”. From 1927 through 1981, US small-cap stocks outperformed large caps by 3.1 percent annualised, according to the Fama-French ‘small-minus-big’ factor. Nonetheless, the finds seemed to be inconsistent, concentrated in January, perhaps due to end of year tax selling pressure, undermining the view that they offer a reliable risk premium. Looking at specific periods, or decades, such as the 1950s, or over the last 20 years, small-caps have actually underperformed against larger cap stocks.

Such results have led the global authority on valuation, Aswath Damodaran, to question the adjustment for three main reasons. First, on closer scrutiny, the historical data, which has been used as the basis of the argument, is yielding more ambiguous results and leading us to question the original judgment that there is a small cap premium. Second, the forward-looking risk premiums, where we look at the market pricing of stocks to get a measure of what investors are demanding as expected returns, are yielding no premiums for small cap stocks. Third, if the justification is intuitive, for example, that smaller firms are riskier than larger firms, much of that additional risk is either diversifiable, better adjusted for in the expected cash flows (instead of the discount rate) or double counted.

He goes on to argue that “The small cap premium is a testimonial to the power of inertia in corporate finance and valuation, where once a practice becomes established, it becomes difficult to challenge, even if the original reasons for it have long since disappeared”.

In the periods when small caps did outperform large caps, the illiquid micro-cap stocks included in the group drove a significant portion of the performance gap. According to Morningstar, “this suggests that the small-cap premium may actually be compensation for liquidity risk”. A few studies have presented direct evidence that liquidity risk helped explain the small-cap premium. Nevertheless, from December 1978 through 2013, the Russell 2000 Index of small-cap US equities had nearly identical performance, as measured by annualised returns, with 12.1 percent as the Russell 1000 and S&P 500 Indexes (12 percent). Moreover, interesting data from Jeremy Siegel argued that the small-cap premium over the S&P 500 between 1926 and 2012 was 1.8 percent, “but if you were to exclude the 1975-1983 period, which coincides with ERISA laws that made it easier for pensions to diversify into small caps, the annual returns for both large and small caps would be almost identical at around 8% per year”. Indeed, Damodaran argues that “even over the long time period that provides the strongest support for existence of a small cap premium, one study finds that removing stocks with less than $5m in market cap causes the small firm effect to vanish. In effect, what you have is microcap premium, isolated in the smallest of stocks, not just small stocks”. There also does not seem to be any such small-cap effect in international emerging markets. Size premiums have “historically been calculated by comparing realised returns on small public company stocks to those on large company stocks. Further, the smallest public companies are often distressed, ignored by institutional investors, or otherwise subject to specific risk factors that render them unsuitable as a basis for measurement”, according to GFData.

Nonetheless, recent research by Asness, Frazzini and Pedersen has started somewhat of an academic fight back based on “measuring stock quality, or its opposite, junk. Junk companies have poor profitability, stagnant growth, high risk and low payouts to investors. Junk stocks unsurprisingly trade at a discount while their high-quality counterparts – those firms that are profitable, growing, low risk and have high payouts to investors – as expected command a premium. The perhaps surprising result is that despite this discount and premium in pricing, quality stocks strongly and significantly outperform junk stocks”. The authors essentially introduce the concept of a ‘quality-minus-junk’ factor that captured this phenomenon.

The key point that practitioners need to define and decide upon is why they think a small stock discount is required. To close this review, we once again turn to Professor Damodaran: “I have never used a small cap premium, when valuing a company and I don’t plan to start now. Needless to say, I am often asked to justify my non-use of a premium and here are my reasons. First, I am not convinced by either the historical data or by current market behaviour that a small cap premium exists. Second, I do believe that small cap companies are more exposed to some risks than large cap companies but there are other more effective devices to bring these risks into valuation. If it is that they are capital constrained (i.e., that it is more difficult for small companies to raise new capital), I will limit their reinvestment and expected growth (thus lowering value). If it is that they have a greater chance of failure, I will estimate a probability of failure and reflect that in my expected value. If it is illiquidity that is your concern, it is worth recognising that one size will not fit all and that the effect on value will vary across investors and across time and will be better captured in a discount on value”.

Adam Paul Patterson is a partner at ALFA Valuation & Advisory. He can be contacted on +55 41 99107 0765 or by email: adam.patterson@alfavaluation.com.br.

Adam Paul Patterson

ALFA Valuation & Advisory