Why Does Small Value Do Well?
Before you tilt your portfolio in the direction of Small Value, you ought to have some logical idea about why it has done well in the past and whether the trend is likely to continue in the future.
The usual explanation is that, as a compensation for extra risk, Small beats Big and Value beats Growth; therefore Small Value beats everything.
But take a look at the data for inflation-adjusted annualized returns for 1927-2005:
| Value | Growth |
| Large Cap | 9.21% | 6.17% |
| Small Cap | 12.13% | 5.77% |
| TSM: | 6.72% |
If Small beats Big, then Small Growth should beat Big Growth... but it doesn't: Small Growth has the worst performance of all.
A Different Theory
So here's an alternative, totally non-scientific theory.
Consider how investors view the different corners of the market:
| Value | Growth |
| Large Cap | Well-known
boring businesses | Well-known
exciting businesses |
| Small Cap | Unknown
boring businesses | The next Microsoft
is in here somewhere! |
The less positive the connotation, the better.
The absolutely bland Small Value companies have nothing going for them besides their intrinsic value, based on their ability to make profits - which is the only place that long-term stock returns can come from.
But paying a premium for a positive connotation will hurt you; and
Small Growth is the worst of all, because it's infested with really exciting companies that offer the hope of amazing returns.
On average these hopes won't materialize; but the price of the hope - the premium you have to pay for the stock, above the companies' intrinsic value - results in a drag on your returns.
(This is like playing roulette in a casino, where your odds are 50/50 minus a little bit for the house: the "little bit" is the price of hope, and it's why you lose.)
In other words, Small Value doesn't select winners so much as reject losers - the kind of companies that produce more excitement than profit (or more buzz than honey).
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