Given recent performance, the question of whether small-cap stocks really do outperform over time has made its way into the financial media. So far, we’ve sought to answer it by considering a multifactor approach and examining international evidence. Today we’ll tackle a behavioral explanation.
The field of behavioral finance provides us with an explanation for the small growth stock anomaly. It exists because investors have a preference for “lottery tickets.”
Nicholas Barberis and Ming Huang—the authors of the NBER working paper, “Stocks as Lotteries: The Implications of Probability Weighting for Security Prices”—found that:
- Investors have a preference for securities that exhibit positive skewness, which occurs in cases where values to the right of (more than) the mean are fewer but farther from it than values to the left of (less than) the mean. Such investments provide the small chance of a huge payoff (winning the lottery). Investors find this small possibility attractive. The result is that positively skewed securities tend to be “overpriced”—they earn negative average excess returns.
- The preference for positively skewed assets explains the existence of several anomalies (deviations from the norm) to the efficient market hypothesis, including the low average return on IPOs, private equity and distressed stocks, despite their high risks.
In theory, we would expect anomalies to be arbitraged away by investors who don’t have a preference for positive skewness. They should be willing to accept the risks of a large loss for the higher expected return that shorting overvalued assets can provide. However, in the real world, anomalies can persist because there are limits to arbitrage.
First, many institutional investors, such as pension plans, endowments and mutual funds, are prohibited by their charters from taking short positions.
Second, the cost of borrowing a stock in order to short it can be expensive, and there can be a limited supply of such stocks available to short.
Third, most investors are unwilling to accept the risks associated with shorting because of the potential for unlimited losses. This is prospect theory at work. The pain of a loss is felt more deeply than the joy of an equal gain.
Fourth, short-sellers run the risk that borrowed securities are recalled before the strategy pays off, as well as the risk that the strategy performs poorly over the short run, triggering an early liquidation.
Taken together, these factors suggest that investors may be unwilling to trade against the overpricing of skewed securities. This allows the anomaly to persist.
The conclusion we can draw is that the issue of the size premium’s “disappearance” may be a function of this “black hole” rather than something that impacts the entire asset class. If you screened out the “black hole” stocks, there would be a size premium that could be captured. Said another way, it’s the higher-quality small stocks that explain the size premium.
Controlling For Quality
Cliff Asness, Andrea Frazzini, Ronen Israel, Tobias Moskowitz and Lasse Pedersen—authors of the January 2015 paper, “Size Matters, If You Control Your Junk”—examined the problem of the disappearing size premium by controlling for the quality factor.
They note: “Stocks with very poor quality (i.e., ‘junk’) are typically very small, have low average returns, and are typically distressed and illiquid securities. These characteristics drive the strong negative relation between size and quality and the returns of these junk stocks chiefly explain the sporadic performance of the size premium and the challenges that have been hurled at it.”
High-quality stocks have the following characteristics: low earnings volatility, high margins, high asset turnover, low financial and operating leverage, and low idiosyncratic risk. The research shows these types of stocks—the kind that Benjamin Graham and Warren Buffett have long advocated buying—outperform low-quality stocks with opposite characteristics (those “lottery-ticket” equities).