Size - Does It Matter?

Feb. 1, 2024, 8:48 a.m. |Factors |Intermediate

Size is one of the earliest factors identified as influencing a stock's future performance. Small stocks have historically tended to generate higher returns than large stocks, which made sense to the academics who studied them. Small companies have a higher potential for growth but also carry higher risks of failure, so investors need to be compensated with greater returns. However, quants began to reconsider their position after the experience of recent years.

Large and small corporations

Size, as with many other prominent factors, didn't enjoy the best decade. It recorded a slightly negative performance throughout the 2010s, meaning that large stocks outperformed small. Though size wasn't the only factor to disappoint investors - value had an even worse decade - quants didn't rush to defend size the way they defended other factors such as value. Cliff Asness, who runs the giant quant firm AQR, even declared that the size effect doesn't exist.

Asness' argument goes like this. Riskier stocks tend to generate higher returns to compensate investors for the risks, and size is not the only factor that encapsulates these risks. Once you control for the influence of these other risk factors, size no longer affects future performance. In other words, if two stocks had different sizes but carried the same amount of risks, we should expect them to perform similarly.

While Asness makes a convincing case, I also think there are reasons that quants haven't discussed that made the recent years a particularly tough decade for the size factor.

From the 2010s, we began to see explosive growth from a handful of technology stocks, which dominated the performance of stock market indices. According to YCharts' research, the S&P 500 returned 15.17% per year for the five years ending in Feb 2022. Without eight giant technology companies, the return would have only been 6.98% annually. Investors fashioned various acronyms to describe these stocks - first, there were the 'FANG' stocks consisting of Facebook, Amazon, Netflix, and Google, which then became 'FAANG' as Apple was inducted. Today, investors often speak of the 'Magnificent Seven' which added NVIDIA, Tesla, and Microsoft (Netflix got the boot).

The technological nature of these stocks makes a big difference. One narrative of why small stocks outperform large stocks goes like this. To generate more revenues, companies must hire more and more employees. Organizing them becomes more complex, and bureaucracy starts to seep in. They thus become slower to react to changes in the business landscape. Small companies are more agile and take the opportunities that larger companies miss.

This narrative holds with more traditional businesses. Take retail, for instance. For Walmart to generate more revenue, it must build new stores and hire more employees. More bureaucracy must accompany increases in revenues. But this principle doesn't necessarily hold for software-centric businesses. If Microsoft lays off many of their employees, its Office suite of products won't suddenly stop working. Sure, the company's revenues could eventually decline without programmers to improve the product, but such a decline will only come slowly and only if competitors strengthen their offerings.

The distinction between traditional and tech businesses exists because, in the former case, employees' work gets consumed, while in the latter, employees generate permanent value. When a Walmart employee scans an item at the checkout counter, that work doesn't leave any lasting effects; the cashier must perform their job again the next day. A piece of code, however, lives forever. It will work just as well tomorrow as it did yesterday, with or without the programmer's presence. So while traditional employees do much of their work to maintain their business proposition, tech employees spend most of their time improving it. As a result, tech companies can hire fewer employees to generate the same amount of revenue, which helps them battle the sinister effects of bureaucracy. At the same time, the value proposition of their products increases continually, which helps them stave off threats from smaller, nimbler challengers.

Will giant tech companies continue their dominance forever? History doesn't favour their odds. The 60s saw similar dominance from a group of large companies called the 'Nifty Fifty.' Investors couldn't fathom that any of them would fall, yet many, such as Sears and Polaroid, did just that. But then again, the Nifty Fifty stocks weren't software businesses. Might the Magnificent Seven fare better? No one knows, but I'm not betting against it.

Disclosure: Dr. Jin Won Choi owns shares of Google and Microsoft.


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