The performance of small value stocks in bear markets

If you have ever seen comparisons of investment returns with and without reinvested dividends, you know that the difference gets huge as the investment horizon increases. Wouldn't it be great you could achieve a similar increase in returns by altering your investment style?

Small cap value stocks have historically achieved much higher returns that typical stocks. Using data from French and Shiller, we can calculate that the average yearly (CAGR) total return with dividends has been 14.3 percent for US small cap value stocks (doubling every 5.2 years) and 10.1 percent for the S&P 500 index (doubling every 7.2 years). This means that it has taken a bit over 18 years for the investment in the small cap value stocks to have become twice as large as the same investment in the index. For comparison, without reinvested dividends, small cap value stocks have returned 10.8 percent (doubling every 6.8 years) and the S&P 500 has returned 6.1 percent (doubling every 11.7 years) in the same time period. The outperformance gap has therefore been a bit over four percent per year historically, which is about as big as the gap between the investment in the index with and without reinvested dividends.

The outperformance of small cap value investing doesn't however come without costs. Value investing has been underperforming for the longest time in history (pdf). Long periods of underperformance are not unusual since the underperformance tends to happen for years at the time, especially during bull markets. In addition to value stocks, the strategy relies on small cap stocks, which have also underperformed large cap stocks during the past ten years in the US (source). Now in the latest bear market, the small cap value strategy has also so far performed worse than the index, of course for a good reason, but it raises the question of what the future performance might look like.

The recent underperformance does not mean that the performance will necessarily continue to be weak in this market, as in this post I'll demonstrate that the strategy has outperformed the index not only during but also after the bottoms of bear markets. Bear markets are defined as markets where the index has fallen more than twenty percent.

The data of small cap value stock returns is from Kenneth French's data library. In the data, the market is split into six parts: small and large companies and low, medium and high book-to-market companies. We'll use the "old" definition of value since the strategy selects companies with the largest book-to-market values, which is the same as selecting companies with the smallest price-to-book values (P/B) excluding also companies with negative book values. We'll use nominal i.e. non-inflation-adjusted returns, and we also take reinvested dividends into account. The returns we'll use are monthly returns, which may not capture the shortest bear markets in the data.

Let's first take a look at the returns beginning from the peak preceding the bear market until for the next ten years after the peak. The green line represents the returns of the small cap value stocks, and the black line represents the returns of the S&P 500, while the black horizontal line represents the boundaries for bear markets.

Click to enlarge images

Since the data is monthly and beginning in 1926, it captured seven different bear markets. Notice that the month and year of the peak are in the title of each of the seven plots. We can see that the small cap value strategy has outperformed in all of the cases except in the Great Depression, and usually by a wide margin. The average return of the index during the ten years was 79.7 percent, or 6.0 percent annually, while the average return of the small cap value strategy was over double at 217 percent, or 12.2 percent annually. The returns were negative only after two out of the seven bear markets for the index, and only once for the small cap value strategy.

Since small cap value has underperformed the index so far in the latest bear market, we should look at how the strategy has performed from the bottoms of the bear markets instead of looking at data beginning at the previous peaks. Below is the same plot but with the bottom of the bear market as the starting point of each plot. This time the title represents the month and the year the market bottomed in instead of when it peaked.

We can of course not know in advance when the bottom will be, but the intention is rather to show whether the performance is weaker after the bottom than during the decline before the bottom. All of the returns were positive from the bottoms of the bear markets, which denotes that none of the bear markets were followed by another bear market that would have exceeded the previous decline. The return for the index for the ten years following the bottom was 242 percent, or 13.1 percent annually, and the return for the small cap value strategy was an astonishing 592 percent, or 21.3 percent annually. This means that the investment would have doubled every 3.6 years! The only time the small cap value strategy underperformed compared to the index was the bear market that bottomed in 2009, but the underperformance wasn't too substantial.

As can be seen from the plots, small cap value is a quite volatile strategy, which in addition tends to underperform for years at the time. It has however been one of the most profitable strategies especially right after a bear market has bottomed. The outperformance has been slightly stronger during the downturns (in relative terms) than from the bottom, achieving a return of almost double that of the index. Since the strategy has outperformed every time except for once from the bottoms of the last seven bear markets, it has a good chance of outperforming the index this time, too. This together with the fact that the returns of the strategy tend to mean revert, i.e. periods of outperformance tend to follow periods of underperformance, makes the strategy to have the one of the best starting points for the following decade.

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The R code used in the analysis can be found here.

Notice that the S&P 500 index has been reconstructed by Shiller for the years it did not exist yet.

The file which includes the small cap value returns in the French data library is called "6 Portfolios Formed on Size and Book-to-Market (2 x 3)".

Notice that the choice of using total return data changes the definition of a bear market and its bottom a bit, but the same seven bear markets would be found also with the price return data.