Small Cup and Value
MAY 2009
The Case for Small Cap and Value
DIMENSIONAL FUND ADVISORS
IN RECENT DECADES, RESEARCHERS HAVE DISCOVERED a number of interesting results by studying the world’s stock markets. Two of the more interesting discoveries are the size effect and the value effect. The size effect refers to the tendency for small cap stocks to have higher average returns than large cap stocks. Banz (1981) shows that this return difference persists after controlling for systematic (beta) risk, and Fama and French (1992) show that it persists after controlling for a number of other factors, including leverage. Companies with high ratios of earnings/price, cash flow/price, and book equity/market equity are frequently referred to as value companies, and firms with low ratios are called growth companies. The value effect refers to the tendency for value stocks to have higher average returns than growth stocks. The value effect was originally documented in the US (Basu 1977; Rosenberg, Reid, and Lanstein 1985), and it was subsequently confirmed to exist in other countries (Capaul, Rowley, and Sharpe 1992; Fama and French 1998; Dimson, Nagel, and Quigley 2003). While the value effect is observed regardless of which of the above-mentioned ratios is used to rank companies, the evidence suggests that the book-to-market ratio has been the most reliable (Fama and French 1992, 1996; Davis and Lee 2008). The purpose of this study is to show updated evidence from various markets on the size and value effects. Evidence on the ability of investors to time these return differences is also examined. The article concludes with a brief analysis of current market valuations.
The material in this publication is provided solely as background information for registered investment advisors, institutional investors, and other sophisticated investors, and is not intended for public use. It should not be distributed to investors of products managed by Dimensional Fund Advisors or to potential
The Case for Small Cap and Value
DIMENSIONAL FUND ADVISORS
IN RECENT DECADES, RESEARCHERS HAVE DISCOVERED a number of interesting results by studying the world’s stock markets. Two of the more interesting discoveries are the size effect and the value effect. The size effect refers to the tendency for small cap stocks to have higher average returns than large cap stocks. Banz (1981) shows that this return difference persists after controlling for systematic (beta) risk, and Fama and French (1992) show that it persists after controlling for a number of other factors, including leverage. Companies with high ratios of earnings/price, cash flow/price, and book equity/market equity are frequently referred to as value companies, and firms with low ratios are called growth companies. The value effect refers to the tendency for value stocks to have higher average returns than growth stocks. The value effect was originally documented in the US (Basu 1977; Rosenberg, Reid, and Lanstein 1985), and it was subsequently confirmed to exist in other countries (Capaul, Rowley, and Sharpe 1992; Fama and French 1998; Dimson, Nagel, and Quigley 2003). While the value effect is observed regardless of which of the above-mentioned ratios is used to rank companies, the evidence suggests that the book-to-market ratio has been the most reliable (Fama and French 1992, 1996; Davis and Lee 2008). The purpose of this study is to show updated evidence from various markets on the size and value effects. Evidence on the ability of investors to time these return differences is also examined. The article concludes with a brief analysis of current market valuations.
The material in this publication is provided solely as background information for registered investment advisors, institutional investors, and other sophisticated investors, and is not intended for public use. It should not be distributed to investors of products managed by Dimensional Fund Advisors or to potential
References: Banz, Rolf W. 1981. The relationship between return and market value of common stocks. Journal of Financial Economics 9:3-18. Basu, Sanjoy. 1977. Investment performance of common stocks in relation to their price-earnings ratios: A test of the efficient market hypothesis. Journal of Finance 32:663-682. Capaul, Carlo, Ian Rowley, and William F. Sharpe. 1993. International value and growth stock returns. Financial Analysts Journal 49:27-36. Davis, James L. 2008a. Is there mean reversion in the value premium? Working paper, Dimensional Fund Advisors. Davis, James L. 2008b. The predictability of risk premiums. Unpublished conference presentation, Dimensional Fund Advisors. Davis, James L., and Inmoo Lee. 2008. Defining value and growth: Implications for returns and turnover. Working paper, Dimensional Fund Advisors. 14 Dimensional Fund Advisors Dimson, Elroy, Stefan Nagel, and Garrett Quigley. 2003. Capturing the Value Premium in the United Kingdom. Financial Analysts Journal 59:35-45. Fama, Eugene F. 1990. Stock returns, expected returns, and real activity. Journal of Finance 45:1089-1108. Fama, Eugene F., and Kenneth R. French. 1992. The cross-section of expected stock returns. Journal of Finance 47:427-465. Fama, Eugene F., and Kenneth R. French. 1993. Common risk factors in the returns on stocks and bonds. Journal of Financial Economics 33:3-56. Fama, Eugene F., and Kenneth R. French. 1996. Multifactor explanations of asset pricing anomalies. Journal of Finance 51:55-84. Fama, Eugene F., and Kenneth R. French. 1998. Value versus growth: The international evidence. Journal of Finance 53:1975-1999. Liew, Jimmy, and Maria Vassalou. 2000. Can book-to-market, size and momentum be risk factors that predict economic growth? Journal of Financial Economics 57:221-245. Perez-Quiros, Gabriel, and Allan Timmermann. 2000. Firm size and cyclical variations in stock returns. Journal of Finance 55:1229-1262. Rosenberg, Barr, Kenneth Reid, and Ronald Lanstein. 1985. Persuasive evidence of market inefficiency. Journal of Portfolio Management 11:9-17. Vassalou, Maria, and Yuhang Xing. 2004. Default risk in equity returns. Journal of Finance 59:831-868. Appendix—Data Descriptions Asia Pacific ex Japan Market: Dimensional Asia Pacific ex Japan Market Index. Asia Pacific ex Japan Small Value: Dimensional Asia Pacific ex Japan Small Value Index. Developed Growth: MSCI EAFE Growth Index (net dividends). Developed Large Cap: MSCI EAFE Index (net dividends). Developed Market: MSCI EAFE Index (net dividends). Developed Small Cap: Dimensional International Small Cap Index. Developed Value: MSCI EAFE Value Index (net dividends). Emerging Growth: Fama/French Emerging Markets Growth Index. Emerging Large Cap: Fama/French Emerging Markets Index . Emerging Market: Dimensional Emerging Markets Index. Emerging Small Cap: Fama/French Emerging Markets Small Cap Index. The Case for Small Cap and Value 15 Emerging Small Value: Dimensional Emerging Markets Small Value Index. Emerging Value: Fama/French Emerging Markets Value Index. Europe ex UK Large Growth: Dimensional Europe ex UK Large Growth Index. Europe ex UK Large Value: Dimensional Europe ex UK Large Value Index. Europe ex UK Small Growth: Dimensional Europe ex UK Small Growth Index. Europe ex UK Small Value: Dimensional Europe ex UK Small Value Index. Global Equity: MSCI World Index (net dividends). Global Large Growth: Dimensional Global Large Growth Index. Global Large Value: Dimensional Global Large Value Index. Global Small Growth: Dimensional Global Small Growth Index. Global Small Value: Dimensional Global Small Value Index. Global Targeted Value: Dimensional Global Targeted Value Index. Japan Market: Dimensional Japan Market Index. Japan Small Value: Dimensional Japan Small Value Index. UK Growth: 50% UK Small Growth and 50% UK Large Growth. UK Large Cap: FTSE All-Share Index. UK Large Growth: Dimensional UK Large Growth Index. UK Large Value: Dimensional UK Large Value Index. UK Market: FTSE All-Share Index. UK Small Cap: Dimensional UK Small Cap Index. UK Small Growth: Dimensional UK Small Growth Index. UK Small Value: Dimensional UK Small Value Index. UK Value: 50% UK Small Value and 50% UK Large Value. US Growth: Fama/French US Growth Index. US Large Cap: CRSP 1-5 Index. US Large Growth: Fama/French US Large Growth Index. US Large Value: Fama/French US Large Value Index. US Market: CRSP Value-Weighted Index. US Small Cap: CRSP 6-10 Index. US Small Growth: Fama/French US Small Growth Index. US Small Value: Fama/French US Small Value Index. US Value: Fama/French US Value Index. FTSE data published with the permission of FTSE. CRSP data provided by the Center for Research in Security Prices, University of Chicago. Fama/French data provided by Fama/French. MSCI data copyright MSCI 2009, all rights reserved. Dimensional indices are compiled by Dimensional from securities data of multiple sources. Each index may contain data from Bloomberg, StyleResearch, the London Business School, and/or Nomura Securities. Definitions of size and value may vary by country. Utilities and REITs are generally excluded, and individual country or company weights may be capped. Composition may vary from one period to another.