How and why do the value premium and size effect work? In their February 2011 paper entitled “Value and Size Puzzles: A Commented Survey”, Kateryna Shapovalova and Alexander Subbotin review and assess prior research on the value premium and size effect, which play key roles in the most widely use factor models of stock prices. Based on the body of research, they conclude that:
- During 1926 through 2009, the gross value premium (size effect) for U.S. stocks averages about 5.0% (3.7%) annually. During 2000 through 2009, the gross value premium (size effect) averages about 5.2% (3.0%) annually.
- There is broad agreement that the value premium and size effect exist, but no consensus on why. The principal alternative explanations are:
- Value and size indicate riskiness in terms of earnings prospects and susceptibility to economic shocks.
- Investors irrationally extrapolate past earnings growth and thus undervalue (overvalue) firms with weak (strong) recent performance; and/or, advisors and analysts tend to recommend relatively well-known stocks with strong recent performance that are easy to market to investors.
- Academia tilts substantially toward the first alternative, while practitioners appear more open to the second.
The paper provides a concise history of the value premium and size effect, illustrating the difficulty of establishing solid theory in finance and the back-and-forth on biases in data and methods.
In summary, a survey of the body of relevant research suggests that most anomaly stakeholders agree that a value premium and a size effect exist, but there is no consensus on why.
Note that premium estimates in the paper (and the bulk of cited past research) are gross. Including simple estimates of trading frictions would materially reduce their magnitudes. Moreover, small stocks and value stocks may tend to have higher trading frictions than large stocks and growth stocks, respectively, in direct opposition to the value premium and size effect.
See also “Evolution of Size Effect Research”.
