Small Cap Effect: “It’s Only a Flesh Wound!”
Apr 18th, 2007 | Filed under: CAPM / Alpha TheoryApparently it’s open season on Fama & French’s 3 factor model. Yesterday on these pages, researchers argued that the value premium was largely explained by transitional distress, not fundamental (”structural”) value. And today we receive word via John Mauldin’s weekly newsletter that Dresdner Kleinwort’s James Montier has leveled an attack on the model’s alleged small-cap outpeformance - leaving 3F proponents taunting us with cries that “it’s only a flesh wound!”.
In this week’s edition of “Outside the Box”, Montier shows how small cap did indeed outperform large cap prior to 1981. But after that time, the outperformance of small cap stocks has been negligible. He chalks this up to the fact that capitalization is a factor of stock price - and stock prices fluctuate. So the capitalization factor implicitly integrates two components: valuation and actual firm size. He cites fundamental indexation guru Rob Arnott’s research that shows the “small cap factor” is dramatically less predictive when it’s based solely on a fundamental metric like sales, as opposed to the traditional market capitalization metric. Apparently, Montier’s own research on European stocks corroborates this observation.
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