Tuesday, March 26, 2013

"Size Matters: The Source of the Small-Cap Premium"

This type of argument is usually more facile than deep and the attempt to transfer a paradigm constructed by observing natural phenomena to business or finance usually results in the Rock Man Syndrome.*
Still, there might be something in here to make a buck off of.
From Above the Market:
Since at least 1981, when Rolf Banz published The Relationship Between Return and Market Value of Common Stocks, the idea of a small cap premium has been pretty well established.  Thus, over time (though it may take a very long time), we can expect higher average returns for common stocks of smaller companies relative to larger companies.  For example, over the period from 1927-2010, the smallest decile of U.S. stocks outperformed the largest decile by 10.4 percent annually.

The standard explanation for this premium is that small-cap stocks are inherently riskier. The idea is that small-cap stocks are more volatile and more sensitive to overall market movements; they’re also more exposed to systematic default risk and business cycle risk.  But I have a non-standard explanation to offer — one that starts with a physicist named Geoffrey West.

West is both brilliant and amazingly innovative.  He needs to be because his goals are both enormous and elusive.  “I’ve always wanted to find the rules that govern everything,” says the theoretical physicist. “It’s amazing that such rules exist. It’s even more amazing that we can find them.”

The lens through which West undertook that search was his long-term fascination with general scaling phenomena.  His quest led him to range beyond physics to the discovery and analysis of the universal scaling laws that pervade biology and to the development of quantitative models for the design of organisms based on underlying universal principles.  The overarching lesson, West asserts, is that as organisms grow in size they become more efficient. ”That is why nature has evolved large animals,” he said. ”It’s a much better way of utilizing energy…. Small may be beautiful, but it is more efficient to be big.”  This is what we think of as economies of scale....MUCH MUCH MORE
HT: The Big Picture

*The Rock Man Syndrome comes from a close reading of Harry Nilsson's The Point!:
...The Rock Man said, "Say, babe, there ain't nothing pointless about this gig. The thing is you see what you want to see and you hear what you want to hear. You dig? Did you ever see Paris?"
"Did you ever see New Delhi?"
"Well, that's it. You see what you want to see and you hear what you want to hear." And with that the Rock Man fell soundly asleep...