This has become deeply embedded in parts of the business valuation community. This is notably the case in North America. The reasons are clear: the USA is the source of most of the small cap studies; it is also an environment in which computation is generally preferred over qualitative methods.
The UK is far from immune from this thought process; it appeared in the two cases of Gul Bottlers v Nichols plc and Gray v Braid Group (Holdings) Limited. In both of these cases the discount rate was increased by 11.65%, representing the premium returns experienced by the smallest listed US companies.
In this article I recount some of the challenges to the concept; in a later article I give some of the arguments for those who support the small stock premium.
Comfortable Words
The small stock premium has a beguiling appeal: it is pleasing to the intuitive senses; it enables a precisely quantified adjustment to be made to discount rates (and multipliers) to reflect the greater vulnerabilities of smaller companies; that adjustment can be referred back to a mass of data from the markets; to those who find appeal in filigree work in business valuation, it offers an extravagant precision which seems unassailable; as if these attractions are not enough, the valuer can also consider that he is carrying out his work in accordance with mainstream business valuation thinking.
It is therefore not surprising that the small stock premium has become, for many, an essential ingrained component of computing the cost of equity capital.
Uncomfortable Sounds
The harmony laid out above, in which returns are seen to increase as companies gradually reduce in size, has been subject to some discordant notes. One powerfully noisy challenge has been made on several occasions by Professor Damodaran, who is seen by many as the academic guru of US business valuation.
In a 2015 paper 'The Small Cap Premium: Where is the Beef?' Aswath Damodaran has summarised the evidence and his views.
How Do Markets React?
If we undertake a thought experiment, one of the immediate challenges to the small stock premium becomes evident. Let us suppose that an imaginary academic study identifies that for some reason (which cannot be fathomed) all listed companies whose names begin with the letter L are subconsciously favoured by market participants, and are habitually over-priced, thereby delivering below market returns to the hapless investors. The fictitious study demonstrates that over the period from 1926 to date, portfolios constructed with no companies which begin with the offending letter, offer premium returns to the canny investor.
Once such a paper had been broadcast and digested by the market, we would expect that the peculiar market inefficiency, having been identified, would almost immediately disappear. That is how we expect broadly efficient markets to react. Those unaware investors would continue to follow their subconscious urgings, but other market participants would take advantage of this by shorting the stocks in question.
This experiment can be challenged as any sort of parallel for the small stock premium: the supporters of the small stock premium make the point that there are sound reasons as to why smaller companies are riskier and should command a higher return.
The Origins of the Small Stock Premium
There was an article by Ralf Banz 'The Relationship between Return and Market Value of Common Stocks' which summarised various papers and which was published in 1981. We therefore have to ask if the very measurement and publishing of the market effect was sufficient to cause its demise.
Professor Damodaran states that from 1926 to 2014 the stocks in the lowest decile made annual returns which were 4.33% more than the market. However he then makes the point that from 1981 to 2014 small cap stocks earned on average 0.18% less than the market each year: the premium returns were therefore all delivered prior to 1981.
What is the Yardstick?
The above description by Professor Damodaran of the small stock premium is at variance with the way that it is normally explained; the conventional approach is to describe the excess return made by the smallest 2.5% of the market (the so called 10 z sector), rather than by the smallest decile. In addition it has become conventional to express the excess return by reference, not to the market, but to the top decile.
The spread of returns from the lowest to the highest decile is 8.31% from 1926 to 2014, but from the lowest to the mid-point is only 4.33%.
An Alternative View
The alternative view is to consider that excess returns which have not been visible since 1981 are a creature of history rather than of current market pricing.
Professor Damodaran summarises his thinking at the start of his article on the use of the small cap premium in valuing companies. He does not mince his words:
'I argue that these practices are misguided because the small cap premium is no longer supported by the historical data, does not seem to be priced in by investors in markets today, and is based on faulty intuition.'
He makes the point that there is a lot of noise in the data with relatively high statistical standard error rates. Even when looking at the whole period from 1926 to 2014 he describes the small cap as fragile, barely making the threshold for statistical significance over the entire period.
Professor Damodaran is renowned in the USA (and elsewhere) for computing and publishing data on forward looking, implied equity risk premiums. These are based on the pricing in the markets and consensus estimates of future cash flows. He has undertaken this exercise for both the S&P 500 and also for the S&P Small Cap 600. His imputed ERPs at 1 January 2015 were 5.78% and 5.44% respectively. Investors therefore do not seem to be pricing in a higher required return for the smaller companies in the US market.
The small stock premium appears simple but it is one of the more complex aspects of business valuation. Many see other possible forces at work, such as the various attributes of liquidity and company quality.
In a further article I consider the arguments of those who support the continued existence of the small stock premium.
Andrew Strickland
Valuation Community, April 2018
