In the ever-evolving landscape of investment strategies, the small-size tilt and the value-tilt have been long-standing approaches that offer compensatory returns for investors. These strategies, rooted in the fundamentals of market behavior, continue to hold relevance and potential profitability even amidst significant technological advancements like the current boom in artificial intelligence (AI). To understand why these tilts should persist in providing market returns, it is crucial to examine their underlying principles and how they tend to interact with periods of intense innovation. (Two other tilts that can be helpful for equity investing—momentum and profitability—are left outside the scope of this modest-length blog article; momentum and profitability are less commonly challenged as to their on-going relevancy.)
The Small-Size Tilt and Its Historical Performance
The small-size tilt refers to the strategy of investing in smaller companies, which historically have outperformed larger companies over long periods. This outperformance, often termed the "small-cap premium," can be attributed to multiple causes. In the U.S. equity markets, small-cap stocks have historically outperformed large-cap stocks by an average of about 2-3% annually over the long term (source: Fama-French data, 1926-2021, available at Kenneth R. French Data Library). However, it is essential to acknowledge that there have been extended periods where small-cap stocks have underperformed. For example, during the 1980s and the mid-2000s, large-cap stocks had notable periods of outperformance.
The higher returns associated with small-cap stocks compensate investors for the greater perceived risk associated with these investments. Small companies also can have higher growth potential due to their relative youth and agility. They can adapt more quickly to market changes and capitalize on niche opportunities that larger firms might overlook. Additionally, small-cap stocks are less widely covered by analysts, leading to greater potential for mispricing and, consequently, higher returns for investors who may identify undervalued opportunities.
Innovation and the Small-Size Tilt
Even in times of great innovation, such as the AI boom, small-cap companies can continue to thrive. Innovation tends to level the playing field, offering small companies the chance to disrupt established industries and compete with larger counterparts. The flexibility and innovative capacity of small firms can be particularly advantageous in rapidly changing technological landscapes. Therefore, the small-size tilt remains a viable strategy as these firms can leverage new technologies to drive growth and capture market share.
The Value-Tilt Strategy: Principles and Performance
Similarly, the value-tilt strategy—which can be applied in tandem with the small-cap tilt—focuses on investing in stocks that are undervalued relative to their fundamentals. Value stocks typically trade at lower price-to-earnings or price-to-book ratios compared to their growth counterparts. The rationale behind this tilt is that the market tends to misprice stocks due to overreactions to short-term news or macroeconomic conditions. In the U.S. equity markets, value stocks have historically outperformed growth stocks by an average of about 4-5% annually over long periods (source: Fama-French data, 1926-2021, available at Kenneth R. French Data Library). Again, it is important to note that value stocks have also experienced periods of underperformance, such as during the late 1990s tech bubble and the recent decade leading up to 2020. The higher returns associated with value stocks compensate investors for the greater perceived risk associated with these investments, which are often in industries facing economic challenges or undergoing restructuring.
Behavioral Finance and Market Biases
For about the past year, through this June, the market experienced a surge in the value of large-cap growth companies, driven by excitement around technological advancements and innovations like AI (in July and early August, there was a pullback). While the term "euphoria" might be too strong, there has certainly been heightened enthusiasm for these stocks. In periods of significant innovation, such as the current AI revolution, value stocks might initially seem less appealing compared to high-flying growth stocks in emerging technologies. However, value investing benefits from the cyclical nature of markets. As enthusiasm for innovation-driven growth stocks reaches exuberant levels, the potential for overvaluation increases. When the market eventually corrects, as perhaps began this July, value stocks often outperform as investors seek stable, fundamentally sound investments. Furthermore, many value stocks can also be beneficiaries of technological advancements. Established companies can invest in and integrate new technologies to enhance their operations and maintain competitive advantages.
Predicting the timing of a market correction is impossible. Therefore, investors are best served by maintaining a value tilt and being patient and confident that it will likely pay off. History suggests that the small-size tilt is also impossible to time, so investors are also best served to maintain that tilt continuously as well.
The persistence of the small-size and value premia in returns, even during technological booms, can be further explained by behavioral finance concepts. Investors are prone to cognitive biases such as overconfidence and herding behavior, which can lead to the overvaluation of popular growth stocks and the neglect of smaller or undervalued firms. This mispricing creates opportunities for disciplined investors who adhere to small-size and value strategies to achieve superior returns.
In Conclusion…
The AI boom, while transformative, does not negate the fundamental principles underpinning small-size and value tilts. Instead, it reinforces the importance of diversification and disciplined investing. AI-driven advancements can create new markets and disrupt existing ones, but they also introduce volatility and uncertainty. In such an environment, maintaining exposure to small-cap and value stocks can provide a hedge against the inherent risks of concentrating solely on high-growth, innovation-focused investments.
At Blair Hall Advisors, we incorporate these tilts with moderation in our investment strategies to balance risk and return effectively.
Blair Hall Advisors always welcomes your thoughts and questions—be it about our wealth management approach, your journey towards financial success, or any other financial concerns you might have. We are thoughtfully expanding our client community. To start a meaningful conversation, feel free to contact us. We’re here to listen and guide.
Note: Copyright, Blair Hall Advisors, LLC. No reproduction or distribution in whole or in part is allowed without our written permission.