How to Beat the Market, Factor 3: Buy Small Cap Value, Not the Big “Glamour” Stocks

US Large Growth vs Small Cap Value, 1980-2018, by Russell Indexes

For the third factor in this series, I wanted to highlight two of the most “classical” factors for classifying and selecting stocks: size (large vs small) and cheapness (growth vs value).  These factors were perhaps most famously identified by academics Eugene Fama and Kenneth French, and popularised in the 3×3 grid used by Morningstar to classify stocks as small, mid, or large cap vs being value, middle or growth.  The research showed that buying small cap value stocks tended to outperform the broader market in the long run, as too much money tends to chase big glamorous stocks up to expectations that are rarely fulfilled.  On the other hand, buying smaller companies that bigger funds can’t or don’t look at yet, and whose profits are likely to generate a good return even with zero or negative growth, is a strategy where it is harder to be disappointed in the long run.  Dimensional Fund Advisors is perhaps one of the best known fund managers applying these factors since the early 1980s.

The below charts show how small cap value has performed vs small cap growth, large cap value and large cap growth over the longest periods of time I could pull up on Bloomberg.  In the US, I used Russell indices, while in Japan, I could only get similar TOPIX indices over a much shorter period of time (when large growth outperforming large value).  In an earlier post, I showed that Hong Kong small caps underperformed the large cap Hang Seng index, but there I was unable to isolate value and other critical factors like buybacks and ownership structure.

The most important detail I noticed in the below chart was how the value indices seemed to almost completely sidestep the 1999-2000 tech stock bubble and crash.  In my view this is because that stock market cycle was driven by valuations that were limited to wall street, while the 2008-2009 crisis was driven more by a systematic shock to main street credit markets.

US Large Growth vs Small Cap Value, 1980-2018, by Russell Indexes
US Large Growth vs Small Cap Value, 1980-2018, by Russell Indexes, Source: Bloomberg

In Japan:

Japan's TOPIX Large Cap Growth vs Small Cap Value, 2009-2018
Japan’s TOPIX Large Cap Growth vs Small Cap Value, 2009-2018, Source: Bloomberg

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