According to University of Chicago professor and Nobel Prize winner Eugene Fama and Professor Kenneth French of Dartmouth, the explanation for the outperformance of certain stocks is due to two main factors, value (cheap beats expensive) and size (small beats large).
Intuitively this makes sense, cheap stocks with a low price to book ratio have a higher chance of reverting to an average valuation and making positive returns. In contrast, buying expensive stocks which revert to an average valuation results in below average returns. For small caps versus large caps, it is easier for a small cap company valued at $1 billion to double in value to $2 billion, than it is for a $100 billion company to double in value to $200 billion, since the size of profits and growth necessary is so much less for the small cap firm.
The outperformance of value and small cap factors is not an every quarter or every year phenomenon, it goes in waves based on starting relative valuations, investor sentiment, and macroeconomic factors affecting profitability (among others).
Small caps did in fact beat out large caps the last 35 years. This ratio is about one standard deviation below average today.
Small cap growth had a rough 35 years losing to small cap value, but performed quite well during the past market cycle. This is partially due to value indices containing a higher percentage of financial sector stocks, which were severly impaired during the financial crisis in 2008.
In a bit of an anomaly, the value factor did not hold for large caps over the last 35 years as growth trumped value. Value did begin outperforming when tech, media, and telecom industries reached the apex in 2000.
Turning to more recent performance in the next chart, over the last five years, small cap growth was the top performer. This was followed by large cap growth, small cap value, and lastly by large cap value.
So far in 2014, all of the roles reversed with small cap growth faltering badly, partly due to biotechnology and social media stocks. Large cap value held up the best with its more defensive oriented sectors such as consumer staples and utilities (and because growth has a higher consumer discretionary sector weight, which underperformed recently).
Differences in performance bring differences in valuation. Using a simple price/book ratio as a proxy for value, we see large cap value and small cap value stocks being near the average of the last ten years. Large cap growth and small cap growth indices are both above one standard deviation rich to the average of the past ten years.
Next, we examine another valuation metric, the five-year normalized price/earnings ratio. Rather than taking one year of earnings and looking back, we take the average of the past five years to account for fluctuations in the business cycle. The middle chart below shows this ratio is near its peak of the last 40 years and above two standard deviations to the average, thus very expensive.
The top part of the graph shows the forward five-year returns, lagged by five years. In this way, we can see what the normalized P/E ratio historically returned at different starting points. Note in the past when the ratio was one standard deviation rich (between the top horizontal red and green lines), returns on a forward five-year basis were around zero. Buying when this ratio is cheap resulted in outsized positive returns. The bottom graph shows that earnings are usually falling when stocks get to a cheap valuation level.
Short-term market movements are difficult to predict, but buying assets that underperformed on long-term time frames and are cheaper than alternatives is one of the factors the Fama & French theory is built upon. In addition, mean reversion is a powerful force in financial markets. With a switch among style and size performance in the first part of 2014 and stark differences among valuations today, considering what style you want in your portfolio is important as ever.
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