The historical data has shown that the value premium is smaller for large-cap securities than for small caps. But new research shows that large-cap investors can increase the premium by pursuing an equal-weighted strategy.
The academic value factor is a long/short portfolio formed by going long value (cheap) stocks and going short growth (expensive) stocks. The empirical research has found that the long/short value factor is generally stronger in smaller capitalization stocks. This should not be a surprise, as small stocks are riskier than large stocks. Over the period 1927-2021, the Fama-French U.S. large-value research index returned an annualized 12.0% versus 14.5% for the Fama-French U.S. small-value index. Over this period the U.S. total stock market (CRSP 1-10 index) returned 10.2%. However, when we confine our lookback to the last 40 years (1982-2021), the outperformance of large-value stocks almost disappears, with the Fama-French U.S. large value research index returning 12.4%, barely outperforming the CRSP 1-10 index return of 12.0%. Over the same period, the Fama-French U.S. small value research index returned 14.8%. In their 2015 paper, “Fact, Fiction, and Value Investing,” Cliff Asness, Andrea Frazzini, Ronen Israel and Tobias Moskowitz reached the conclusion that “by itself, value is surprisingly weak among large-cap stocks.” Such evidence has caused many to question the benefits of long-only value investing.
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In his April 2022 paper, “Long-Only Value Investing: Does Size Matter?” Alpha Architect’s Jack Vogel took an interesting look into the value premium and the ability of the typical long-only investor to capture it. He examined long-only value portfolios to determine if size is a less important factor. He chose to compare equal-weighted (EW) large-cap value portfolios to small-cap value portfolios (without microcaps, as they have limited liquidity and can be expensive to trade). Vogel chose an equal-weighting scheme for large value to eliminate the potential influence of a handful of mega-large-cap stocks from driving the results associated with value-weighted (VW, or market-cap weighted) portfolios. By definition, an EW scheme will impart a small-cap tilt to the portfolio relative to a VW scheme.
Vogel’s data sample covered the period July 1973-December 2020 and included stocks traded on the NYSE, AMEX and Nasdaq. He identified the 1,000 largest firms (about 90% of the total market capitalization) as large-cap stocks and the smallest 2,000 firms as small-cap stocks. He divided portfolios into either terciles (three groups), quintiles (five groups) or deciles (10 groups) on each of the various value measures used – book-to-market (B/M), earnings-to-price (E/P), cash flow-to-price (CF/P), enterprise multiple (EBIT/TEV) and a composite of the four. For developed international markets (the countries included in the MSCI EAFE Index), data covered the period 1994-2020. All portfolios were formed on June 30 each year and held for 12 months. Following is a summary of his findings:
- EW large-cap value portfolios and small-cap value portfolios (both market-cap weighted and equal weighted) earned statistically similar returns – the average monthly return to large-cap EW (1.29%) was very close to the small-cap value portfolios’ monthly return, either 1.36% (VW) or 1.39% (EW). That does not consider the higher trading costs of small-cap portfolios.
- While they earned similar returns, the EW large-cap value portfolio had vastly superior liquidity characteristics relative to the small-cap equivalent.
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- Large-cap EW portfolios had a position-weighted market capitalization that was, on average, 19.27 times the EW small-cap value portfolio and 12.74 times the VW small-cap value portfolio.
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- The average daily volume (ADV) of the large-cap portfolios was 18.72 times the ADV of the EW small-cap portfolios and 11.66 times that of the VW small-cap value portfolios.
- The results were robust to various value metrics, to subperiods, to including microcaps and to other tests.
- Factor regressions (versus the Carhart four-factor, Fama-French five- and six-factor (plus momentum), and Q-factor models) showed that large-cap EW value portfolios and small-cap value portfolios have statistically indistinguishable historical returns, even after accounting for additional factors.
- Using the composite value metric, the average discount of large-cap stocks relative to small stocks was 12% (e.g., a P/E of 10 versus a P/E of 8.8.). Thus, one should expect slightly stronger performance for small-cap value portfolios relative to large-cap value (EW) portfolios.
- International results were similar. For example, using the composite EW for large value produced a return of 92 basis points (bps) per month versus 99 bps per month for both EW and VW small value.
His findings led Vogel to conclude: “The critical implication of this research, and its importance to systematic value investors, is that smaller is not always better. In fact, given the significantly higher liquidity among equal-weighted large-cap value portfolios, the data suggests that value investors who prefer liquidity should prefer equal-weighted large-cap value portfolios. … If nothing else, the data suggests that practitioners should split their value allocations across the large-cap value (equal-weighted) and small-cap value since these portfolios have zero overlap but similar historical returns, highlighting a potential diversification benefit.” He added: “This paper is not saying that the academic value factor, a long/short portfolio, does not work better in small-cap stocks. In unreported results … the academic value factor, a long/short portfolio, is weak amongst large-cap stocks while showing better performance in small-cap stocks.”
Read the full article here by Larry Swedroe, Advisor Perspectives.
