Size matters in investing as much as in other human endeavors. Bigger is better for most activities; Goliath usually defeats David. But financial economists have known for decades that small is the new big: investing in smaller firms increases investor returns a great deal over investing in the Blue Chips. Eugene Fama had to add firm size and value investing, to the Capital Asset Pricing Model to make it work.
Recently the journal of the American Association of Individual Investors carried an article in its January issue on the subject of firm size, “Exploiting the Relative Outperformance of Small-Cap Stocks” by John B. Davenport, Ph.D., and M. Fred Meissner. The conclusions are striking:
• Small caps outperformed large caps 51% of the time between 1926 and 2012, but realized a cumulative excess return of 253%.• Investors have higher probabilities of capturing small-cap excess returns in times of economic expansion immediately following recessionary periods.• Small-cap sectors realize higher returns than large-cap stocks when the large-cap sectors are in favor.
A popular fallacy considers entrepreneurial profit a reward for risk taking. It looks upon the entrepreneur as a gambler who invests in a lottery after having weighed the favorable chances of winning a prize against the unfavorable chances of losing his stake. This opinion manifests itself most clearly in the description of stock-exchange transactions as a sort of gambling.The owner of capital does not choose between more risky, less risky, and safe investments. He is forced, by the very operation of the market economy, to invest his funds in such a way as to supply the most urgent needs of the consumers to the best possible extent.There is no such thing as a safe investment. If capitalists were to behave in the way the risk fable describes and were to strive after what they consider to be the safest investment, their conduct would render this line of investment unsafe and they would certainly lose their input. For the capitalist there is no means of evading the law of the market that makes it imperative for the investor to comply with the wishes of the consumers and to produce all that can be produced under the given state of capital supply, technological knowledge, and the valuations of the consumers. A capitalist never chooses that investment in which, according to his understanding of the future, the danger of losing his input is smallest. He chooses that investment in which he expects to make the highest possible profit.It is customary to call venture capital risk capital. However, as has been pointed out, the success or failure of the investment in preferred stock, bonds, debentures, mortgages, and other loans depends ultimately also on the same factors that determine success or failure of the venture capital invested. There is no such thing as independence of the vicissitudes of the market.
Of course, a mainstream economist would claim that risk isn’t the only factor they consider. They look at the tradeoffs between risk and reward. However, risk measured by volatility, as in the Sharpe ratio, is a poor definition of risk, as I show in my book, FinancialBull Riding. Proponents assume that markets are random events like games in casinos. But they're not. Risk should be uncertainty, which investors can reduce by greater knowledge. Assuming randomness causes investors to take on too much systematic risk while ignoring great opportunities.
So if risk doesn’t explain the larger returns to small cap stocks, what does? I believe it has to do with the socialist calculation problem. As firms become larger, they begin to function like small socialist economies which lack the tacit knowledge of the man on the production line about demand and prices. The larger the firm, the less management possesses the necessary knowledge to guide decision making and the firm becomes less efficient in its use of resources and in capturing fleeting opportunities. Some large firms can overcome the problem with radical decentralization of decision making, but few managers of large firms are humble enough to practice that.
I cover the second point from the AAII journal article, timing entries and exits using business cycle theory, in detail in my book, too. The biggest returns always come in the first year or two after the recession.