Size vs value: what to consider when factor investing

In the previous article we outlined how factor investing is an investment approach that involves targeting quantifiable characteristics or ‘factors’ that can explain differences in security returns.

Having previously explored the quality and minimum volatility factors, this article will focus on the size and value factors.

The size factor

The size factor relates to the phenomenon where companies with a lower market capitalisation (that is, small-cap companies), tend to exhibit a return premium over companies with a large market capitalisation.

Typically, a company with a market cap of between approximately $300mn (£236mn) and $2bn is defined as a small-cap stock.

However, other methods can also be used in determining small-cap stocks. For example, when observing an index, the bottom 10 per cent to 15 per cent of companies in terms of market capitalisation could be labelled as small cap.

Concerns about asymmetric information could be a key reason why some investors avoid focusing their investments in small-cap stocks.

Building off earlier research that found that over the long-term smaller companies tend to deliver a higher premium than larger ones, Eugene Fama and Kenneth French are widely credited for firmly establishing the small-cap premium with the 'three-factor model', put forward in their paper "The Cross-Section of Expected Stock Returns" (1992).

This model built off William Sharpe’s capital asset pricing model (CAPM) (1964), which put forward that all stocks have some sensitivity to the movement of the broader market (beta), and suggested that a single factor, market exposure, drives the risk and returns of stocks.

Fama and French introduced two additional factors: size, measured by market capitalisation, and value, measured by the book-to-market ratio.

The resulting three-factor model explained more than 90 per cent of the variation in diversified portfolio returns, compared to the approximately 70 per cent of returns explained by the earlier CAPM model.

There are a number of potential explanations behind why the size factor might add value compared to the broad market. These include risk-based explanations, which are founded on excess risk-adjusted returns being achievable due to investors undertaking financial risks, and behavioural-based explanations, which are founded on investor psychology and expectations.

Risk-based explanations for the size factor include the simple rationale that small firms typically have higher financial leverage (debt), less liquidity, lower profitability, higher volatility, and a higher risk of bankruptcy, leading to investors demanding a premium to be compensated for this additional risk.

Additionally, Klein and Bawa (1977) and Merton (1987) put forward that only some investors have the resources to gather information on small companies, which might be quite opaque in nature.

They suggested that concerns about asymmetric information could be a key reason why some investors avoid focusing their investments in small-cap stocks.