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Groundbreaking investment research from 1992—supported by other studies since then—indicates that value stocks and small stocks outperform the stock market as a whole. Recently, professors Eugene F. Fama of the University of Chicago and Kenneth R. French of Dartmouth—authors of the 1992 study—have identified another important component of stock returns: the higher returns of small and value stocks are due to a small subset of stocks in each category that become very successful. If those small groups of stocks were not included in the overall results, neither small stocks as a whole nor value stocks would have offered any extra returns.
Fama and French define small stocks as the 20% of listed stocks with the smallest market capitalizations, meaning their share prices multiplied by the number of shares outstanding. Value stocks are those with low prices compared to their book values, while growth stocks have high prices compared to book value.
In a working paper titled “Migration,” Fama and French say they found that a small number of successful value and small stocks migrated out of their respective sectors each year. For instance, a company that starts out small, such as Microsoft, becomes wildly successful and its stock soars, pushing it into the big stock category. The returns of these outliers account for all the extra returns small and value stock investors earn over the stock market. Fama and French used 80 years of historical data to construct portfolios that were rebalanced annually to include stocks that fit the strict characteristics of each category. From 1927 through 2006, for instance, small value stocks produced a 22.5% annualized gain. But if the few stocks that grew out of the small value category each year were excluded from the portfolio, it grew at only 13.1%, less than the stock market as a whole.
This means investors will find it hard to capture the small and value effects by picking individual stocks—there is too much room for error. Instead, they should stick to broad asset class portfolios that capture the majority of each asset class.