Can value and small companies outperform forever?

[smjsl]

@Texas Proud, bamsphd: To clarify, I am NOT saying it's the same set of stocks that will never change. Of course I realize small companies will become large and large companies will become small. Some value companies will become growth and vice versa.

Please take a look at my example again. It's really really simple: Person A buys 10k worth of small value index fund (e.g. VISVX) and holds it forever. Person B buys 10k worth of total US market index (e.g. VTSMX) fund and also holds it forever. (And yes, all dividends / cap gains are reinvested.)

These are real funds. Obviously the funds will kick out no-longer qualifying stocks and start buying other ones. I am not disputing this in any way.

My question (1) is - do you believe Person A will outperfom Person B?

Question (2): If you answered yes to (1), do you see any issue with the following paragraph of my example: "If you believe that over long period of time person A's fund will grow at the rate of 9% and person B's fund will grow at the rate of 8%, then eventually (240 years from now) person A's holding will be 90% of combined person A and person B's holding."

Thank you for your responses

 

[Midpack]

Please take a look at my example again. It's really really simple: Person A buys 10k worth of small value index fund (e.g. VISVX) and holds it forever. Person B buys 10k worth of total US market index (e.g. VTSMX) fund and also holds it forever. (And yes, all dividends / cap gains are reinvested.)

These are real funds. Obviously the funds will kick out no-longer qualifying stocks and start buying other ones. I am not disputing this in any way.

My question (1) is - do you believe Person A will outperfom Person B?

Question (2): If you answered yes to (1), do you see any issue with the following paragraph of my example: "If you believe that over long period of time person A's fund will grow at the rate of 9% and person B's fund will grow at the rate of 8%, then eventually (240 years from now) person A's holding will be 90% of combined person A and person B's holding."

Thank you for your responses

Answer 1) Yes
Answer 2) Yes, if the performance of the past 10 years continues for the funds you mention, the small cap will be 90% of the combined holdings in about 35 years. However, 240 years is more statistically likely.

 

[Texas Proud]

@Texas Proud, bamsphd: To clarify, I am NOT saying it's the same set of stocks that will never change. Of course I realize small companies will become large and large companies will become small. Some value companies will become growth and vice versa.

Please take a look at my example again. It's really really simple: Person A buys 10k worth of small value index fund (e.g. VISVX) and holds it forever. Person B buys 10k worth of total US market index (e.g. VTSMX) fund and also holds it forever. (And yes, all dividends / cap gains are reinvested.)

These are real funds. Obviously the funds will kick out no-longer qualifying stocks and start buying other ones. I am not disputing this in any way.

My question (1) is - do you believe Person A will outperfom Person B?

Question (2): If you answered yes to (1), do you see any issue with the following paragraph of my example: "If you believe that over long period of time person A's fund will grow at the rate of 9% and person B's fund will grow at the rate of 8%, then eventually (240 years from now) person A's holding will be 90% of combined person A and person B's holding."

Thank you for your responses

1. Yes.

2. Yes


But who cares? It is something that is irrelevent in determining what to invest in NOW...

The problem is that 9% is not a steady 9% a year increase... as we have seen, there could be a 50% to 70% drop in ONE year... but then a big huge increase in others... since an investor for retirement plans to use some of that money.... they do not want to take the risks involved to get that 9%... so they go large and probably have less risk.....

 

[bamsphd]

My question (1) is - do you believe Person A will outperfom Person B?

I personally am overweight "small" in my US investments. I think this might increase my total return, but is pretty certain to increase the volatility of my portfolio. So yes, over the next few decades person A's investment has a better than 50% chance of outperforming person B's investment.

Question (2): If you answered yes to (1), do you see any issue with the following paragraph of my example: "If you believe that over long period of time person A's fund will grow at the rate of 9% and person B's fund will grow at the rate of 8%, then eventually (240 years from now) person A's holding will be 90% of combined person A and person B's holding."

I expect the premium for small stocks to decrease over time, if it is not already gone. A premium for small stocks made sense when it was impractical for most investors to make broadly diversified investments in small stocks. That keeps becoming far less of an issue, so I expect the premium to decline. I certainly don't expect the premium to remain at the levels seen historically for the next 240 years.

I would also observe that EVENTUALLY, the small cap fund will experience a black swan event which wipes out its entire value. It is possible that event will also take out the total stock market fund, but some scenarios would allow the total stock market fund to survive because of its greater diversification.

Footnote: I definitely don't assume 9% and 8% rates of return, but assume those were made up for your example.

 

[samclem]

A premium for small stocks made sense when it was impractical for most investors to make broadly diversified investments in small stocks.

I don't follow your reasoning here. If it has gotten easier to invest in small stocks, then we should expect:
a) That there would be greater liquidity in small stocks now, and this would lead to better pricing efficiency. No direct impact on returns, but it is likely investors would value small stocks more highly overall if they could be sure they could sell them more easily in the future.
b) There would be more money flowing into small stocks (increased demand), which would increase their prices, not decrease them. This would be a one-time deal.

I guess maybe the "small premium" might go down because of the two factors above if we look at dividend return per dollar invested (due to the higher share prices)?

Footnote: I definitely don't assume 9% and 8% rates of return

I concur.

 

[smjsl]

Thanks for all the replies so far. My responses below.

But who cares? It is something that is irrelevent in determining what to invest in NOW...

I think it's very much relevant to what to invest in. I care because I want to decide whether over the next 30-60 years I want to weight my portfolio more towards small/value or not.

So yes, over the next few decades person A's investment has a better than 50% chance of outperforming person B's investment.
[...]
I expect the premium for small stocks to decrease over time, if it is not already gone. A premium for small stocks made sense when it was impractical for most investors to make broadly diversified investments in small stocks.

So you are saying that you think NOW there is a premium but later there will not be. Ok, I guess that's a possibility. I am not following the second part though - I would think market had more than a few years to adjust for availability of broadly diversified investments in small caps.. and so if you believe in efficient markets, that would be way more than enough time to adjust...

Footnote: I definitely don't assume 9% and 8% rates of return, but assume those were made up for your example.

Of course.

Yes, if the performance of the past 10 years continues for the funds you mention, the small cap will be 90% of the combined holdings in about 35 years. However, 240 years is more statistically likely.

I did not understand the last sentence.

 

[bamsphd]

I don't follow your reasoning here. If it has gotten easier to invest in small stocks, then we should expect:
a) That there would be greater liquidity in small stocks now, and this would lead to better pricing efficiency. No direct impact on returns, but it is likely investors would value small stocks more highly overall if they could be sure they could sell them more easily in the future.
b) There would be more money flowing into small stocks (increased demand), which would increase their prices, not decrease them. This would be a one-time deal.

I guess maybe the "small premium" might go down because of the two factors above if we look at dividend return per dollar invested (due to the higher share prices)?

I think your last paragraph is definitely an argument for the "premium" to disappear, since I presume we are measuring from NOW, not from some date in the past.

My basic argument is that you are not paid for a risk most investors can easily diversify away. In the past, without index funds, and with much higher individual transaction costs, few investors could easily diversify away as much specific company risk as they can today. So they were more adverse to the possibility that one of the few stocks in their portfolio might go bankrupt than the odds of bankruptcy in the total set of stocks would suggest. Basically, with a small portfolio, the standard deviation of the portfolio can be a significant risk. Thus such investors demanded an extra premium for investing in the small and value stocks that they perceived were more dangerous.

Today, there are still many investors who have not adopted a widely diversified portfolio approach. Those investors would still tend to want a premium for small and value stocks. However, there are also investors such as myself who can diversify away that risk, and only care about the remaining statistical differences in risk between small and large stocks. At some point there will be enough investors like me, that the historical premium caused by portfolio risk should disappear. In fact I worry that we might over-shoot in the opposite direction. Too many people like me chasing the historical premium invest in small stocks destroying the premium we chase.

The premium may already have disappeared. However, it is hard to tell, because every now and then we get great depressions/recessions which tend to cause a higher percentage of small and value companies to fail, than solid growth companies. So there should be a premium to account for that risk, even if the historical portfolio risk premium has disappeared. Over a long enough time period, that remaining premium should be pretty much a wash, eliminated by the occasional bouts of mass bankruptcies. However, over a shorter period, there may seem to be a premium.

It reminds me of the difference between junk bonds and treasuries. In good times, junk bonds seem to pay a premium. In rough times, junk bonds default, and treasuries seem to have been the better investment.

 

[Texas Proud]

Since you say you are trying to invest NOW and not worried about the 240 year example (which is what I was talking about being irrelevent)...

Small companies usually are more risky... people demand a higher return for this risk... this will not change over time... this will not change because some become 'big'...

Take a look at the last 100 years... using your example, there should not be any 'small' companies... but there are... because new companies continue to be created all the time... they usually start out small.. there are many Fortune 500 companies that did not exist when I was born.. and a number that did that are gone...

Also, the definition of what 'small' is will change over time... back in the 70s a company that was 10 bill was very big... the largest bank in the US only had 100 bill in assets... now we have companies valued at 250 bill and more.... banks have 2 TRILLION in assets... but there are still plenty of small companies...

 

[samclem]

In fact I worry that we might over-shoot in the opposite direction. Too many people like me chasing the historical premium invest in small stocks destroying the premium we chase.

This could happen, and I'll be taking the risk with you. There are other possible reasons that small stocks are undervalued that have nothing to do with the ease/difficulty in buying them. After all, value stocks are also undervalued, and they are just as easy to buy as growth stocks. As mentioned previously, one theory for the perstant outperformance of value stocks is that investors believe these sickly companies are most vulnerable to having poor returns just when investors most desire good returns--when the market is taking a dive or the general economy is depressed. Irrational investor fear drives their prices down below their fundamentals. Could the same factor be at the bottom of the small stock premium? These smaller companies have fewer resources to draw on in tough times, and their quarterly balance sheets are more variable than the larger companies. These are both factors that could drive away investors to an irrational degree.

I don't know for certain why there is a small and a value premium. I could come up with 20 reasons they might diminish in the future--and 20 reasons why they could grow in the future. I'm just going to stay with the latest evidence and continue to watch.

 

[bamsphd]

I don't know for certain why there is a small and a value premium. I could come up with 20 reasons they might diminish in the future--and 20 reasons why they could grow in the future. I'm just going to stay with the latest evidence and continue to watch.

I agree, and that is where I have placed my bets.

 

[Gone4Good]

But, that's a bet you can take--just bet against the value premium. And in another decade or so you'll likely have your own answer to another question: "who pays for the value premium?"

 

[Gone4Good]

My question (1) is - do you believe Person A will outperfom Person B?

Question (2): If you answered yes to (1), do you see any issue with the following paragraph of my example: "If you believe that over long period of time person A's fund will grow at the rate of 9% and person B's fund will grow at the rate of 8%, then eventually (240 years from now) person A's holding will be 90% of combined person A and person B's holding."

Thank you for your responses

Yes to both.

I think the confusion is that most of us assumed you were implying that their was some conflict between both 1 and 2 being true. But really what you're asking is "can two different investments have dramatically different return profiles" and the answer to that question is "of course". Think Google and Pets.com where Person A's holdings is infinitely higher than Person B's holdings (and it took a lot less than 240 years, too).

 

[smjsl]

Yes to both.

I think the confusion is that most of us assumed you were implying that their was some conflict between both 1 and 2 being true. But really what you're asking is "can two different investments have dramatically different return profiles" and the answer to that question is "of course".

Well, part of (2) is kind of asking whether you see a conflict or not. If your small / value holding is now 90% of your total market holding, the only reason overall small/value companies are still a small percentage of overall market is if there was a lot more influx over the years into that category compared to non-small/non-value category. In other words, overall added market cap of non-small companies is much larger than that of the small ones; and by the same token, overall added market cap of growth companies over the years has to be much more than that of the value ones. Perhaps that's the answer.