Financial Analysts Journal

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The Value Premium for Small-Capitalization Stocks

Manjeet S. Dhatt, Yong H. Kim & Sandip Mukherji

To cite this article: Manjeet S. Dhatt, Yong H. Kim & Sandip Mukherji (1999) The Value
Premium for Small-Capitalization Stocks, Financial Analysts Journal, 55:5, 60-68, DOI: 10.2469/
faj.v55.n5.2300

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 The Value Premium for
Small-Capitalization Stocks
Manjeet S. Dhatt, Yong H. Kim, and Sandip Mukherji
We investigated whether an exploitable value premium existed for stocks in
the Russell 2000 Index, the commonly used U.S. small-cap benchmark, in
the 1979–97 period. For portfolios formed on the basis of price-to-earnings,
price-to-sales, and market-to-book ratios, value stocks in the study
outperformed growth stocks by 5.28–8.40 percentage points a year and had
lower standard deviations and lower coefficients of variation than growth
stocks did. Combining the valuation measures to identify value boosted
returns and improved the risk–return characteristics of value portfolios.
Most of the value premium for small-cap stocks occurred outside the month
of January and was available for reasonably liquid stocks. These findings
suggest that small-cap stocks offer a substantial value premium that is of
practical significance to investors.

S
everal studies have documented significant
relationships between stock returns and
company-specific variables. Banz (1981)
showed that small-cap stocks earn higher
returns than large-cap stocks. Other researchers
found that value stocks outperform growth stocks
over long periods of time. The value premium was
shown to be available when various ratios were
used—P/E (Basu 1977), book-to-market value
(Fama and French 1992), and sales-to-price ratio
(Barbee, Mukherji, and Raines 1996).
Studies investigating the size and value effects
reveal interesting insights. Keim (1983) and Blume
and Stambaugh (1983) found that the size effect is
confined to January, which indicates that it is
reflecting the January effect. Fama and French dem-
onstrated that stock returns are related more
strongly to book-to-market value ratios than to
market values of equity and that these two vari-
ables capture the explanatory power of the
earnings-to-price ratio. Barbee et al. showed that
sales to price absorbs the roles of the
book-to-market ratio and market value of equity in
explaining stock returns. The collective evidence
from these studies indicates that the value premium
Manjeet S. Dhatt is assistant professor of finance at the
University of Michigan at Dearborn. Yong H. Kim is
professor of finance at the University of Cincinnati.
Sandip Mukherji is associate professor of finance at
Howard University.
is more significant than the size effect, but the most
efficient measure of value is not well established.
A recent article by Loughran (1997) questioned
the practical significance of the size and value pre-
miums. He found that stocks in the smallest size
quintile have the largest book-to-market effect and
stocks in the largest size quintile do not have a
significant book-to-market effect. Furthermore, in
multiple regressions of 11-month returns, exclud-
ing January, the size coefficient was not significant
and the significance of the book-to-market coeffi-
cient was considerably reduced when small-cap
growth stocks were excluded from the sample.
Loughran concluded that the size and
book-to-market effects may have only limited
importance for portfolio allocation for most money
managers.
Loughran’s findings do not imply that no
value premium is available to investors. The only
measure of value he examined was book to market.
Furthermore, he found no book-to-market effect
for large-cap stocks, which are widely followed
and are thus unlikely to offer any long-term pre-
mium based on fundamental analysis. He found
that the largest book-to-market effect occurs for
the smallest-cap stocks, which suffer from low
liquidity and may not be a practical investment
option for most investors.
An interesting question raised by Loughran’s
study is whether a significant value premium exists
for stocks that do not belong in the smallest or
largest size groups and are, therefore, reasonably

60 Association for Investment Management and Research


liquid but not widely followed. The existence of an
exploitable value premium for small-cap stocks
would be of particular interest to managers of
small-cap funds and individual investors with lim-
ited funds to invest, but it would also be significant
for all investors and managers because small-cap
stocks have a place in any broadly diversified port-
folio.
The primary goal of the study reported here
was to determine whether U.S. small-cap stocks
offer an exploitable value premium. We also exam-
ined the relative efficiency of common value mea-
sures for identifying small-cap stocks with superior
risk–return characteristics. And in the light of evi-
dence that results vary when different value mea-
sures are used, we present a new approach for
investigating whether using a combination of value
measures to identify value stocks can improve per-
formance.
Data and Methodology
Our sample consisted of stocks in the Russell 2000
Index, which excludes the 1,000 largest stocks and
includes the stocks that are ranked 1,001 through
3,000 in terms of total market capitalization.1 We
obtained details of Russell 2000 companies from
Frank Russell Company.
A sample consisting of stocks that compose the
Russell 2000 has several advantages over samples
that include all small-cap stocks. Because the index
stocks are the relatively larger small-cap stocks,
most investors can invest in them without incur-
ring prohibitive liquidity costs. Furthermore,
because this index is the common benchmark for
small-cap stocks, the results of investment strate-
gies involving the index stocks have practical sig-
nificance. Finally, data on these relatively large
small-cap stocks are less likely to be affected by
survivorship bias than data on samples that include
the smallest-cap stocks.
Russell 2000 data from 1979 to the present are
available; changes in the composition of the index
are made on the basis of total market capitalizations
at the end of June each year. Our study covered the
18-year period of July 1979 through June 1997.
Because our accounting and market data are
from Compustat, we first tried to identify the
CUSIP number of each of the index companies in
the Compustat databases. Where the CUSIP cate-
gory could not be readily identified (mainly
because of name changes, mergers, and acquisi-
tions), we explored secondary sources, such as
Standard & Poor’s Corporation records and
Moody’s Investor Services company manuals. We
also requested help from Frank Russell Company
September/October 1999
The Value Premium for Small-Capitalization Stocks
and Standard & Poor’s to locate the missing com-
panies. Through all these sources, we were able to
identify 1,981 of the 2,000 index companies on the
Compustat databases, per year, on average.2 The
identifiable companies account for 98.99 percent,
on average, of the total market value of the index
companies. Because fewer than 1 percent of the
sample companies are missing, and these compa-
nies are slightly larger than average, our results are
unlikely to have been significantly affected by sur-
vivorship bias.
We used the current market data and the most
recent publicly available accounting data to com-
pute the following variables for each company at
the end of June each year:
• market value of equity—Number of shares out-
standing in the previous fiscal year × Stock
price at the end of June;
• P/E—Stock price at the end of June/Fully
diluted EPS, excluding extraordinary items
and discontinued operations, in the previous
fiscal year;
• price to sales (P/S)—Stock price at the end of
June/Net sales per share in the previous fiscal
year;
• market value to book value (M/B)—Stock price at
the end of June/Book value per share at the end
of the previous fiscal year.
To avoid a look-ahead bias, we used account-
ing data with the three-month reporting lag permit-
ted by the U.S. SEC. Accordingly, for companies
with fiscal years ending in July through March, we
used accounting data from the most recent fiscal
year, whereas for companies with fiscal years end-
ing in April through June, we used data from the
fiscal year preceding the most recent one.
For each stock in our sample at the end of June
each year (rank period), we calculated the follow-
ing returns for the subsequent July through June
(test period):
• buy-and-hold annual return—the compounded
monthly returns assuming reinvestment of
dividends;
• cumulative annual return—the aggregate month-
ly returns;
• average monthly return—the aggregate monthly
returns divided by the number of months with
returns available.
In addition to these results, we report means,
standard deviations, and coefficients of variation
for equally weighted annual average monthly
returns of portfolios with low, medium, and high
positive values of market value of equity, P/E, P/S,
and M/B and for portfolios with negative values of
P/E, P/S, and M/B. We also report similar statistics
for portfolios composed by combining stocks with
61
Financial Analysts Journal

consistently low (but positive) values by the three
valuation ratios into one portfolio, consistently
medium positive values into another portfolio, and
consistently high positive values into a third portfo-
lio. We rebalanced all portfolios each year on the
basis of the end-of-June ratios for the stocks in the
reconstituted Russell 2000.
We conducted two-tailed t-tests for significant
differences in the returns of value and growth port-
folios constructed on the basis of individual valua-
tion ratios and the combined portfolios. Finally, we
report the results for the combined portfolios for 12
months, for January alone, and for the other 11
months—with and without low-liquidity stocks.
Sample Characteristics
Mean and median market capitalizations and val-
uations of the sample companies varied widely.
Table 1 shows the means of the annual means for
market value of equity (MVE) to be $140.77 million.
Annual mean (median) MVE increased from $46.71
($34.24) million in 1979 to $417.59 ($349.68) million
in 1996. The sample companies are, therefore, fairly
large for small caps. The coefficients of variation
indicate that market value of equity and P/S have
the greatest variability among the four variables.
(In subsequent tables, we report the medians of
annual medians, which are more representative of
the distribution of these variables than the means
of annual means.)
The means of annual means and medians of
annual medians of the returns are quite different
for the buy-and-hold annual return (BAR) but
fairly close for the cumulative annual return (CAR)
and average monthly return (AMR). The coeffi-
cients of variation also indicate that the BAR is
more variable than the CAR and AMR. Fama (1998)
suggested that tests of long-term returns should be
based on the AMR or CAR rather than the BAR,
which is susceptible to statistical problems, such as
extreme skewness. Our subsequent results are
based on the AMR, which is the return measure
least influenced by outliers.3
Performance of Portfolios
We report here the performance of portfolios based
on company size and low, medium, and high valu-
ation ratios (by individual ratio) and performance
of the combined low-ratio, medium-ratio, and
high-ratio portfolios.
Variations in Size and Valuation. Perfor-
mance of portfolios with negative values4 and three
approximately equal sized5 portfolios with low,
medium, and high positive values of each of the four
variables for the 18-year study period is shown in
Table 2. Results for the portfolios based on size
(market value of equity) show that the small compa-
nies in the sample had the lowest AMRs and highest
standard deviations and the large companies had
the highest AMRs and lowest standard deviations.
Consequently, large companies have much lower
coefficients of variation than small companies. These
results indicate that among the small stocks of the
Russell 2000, the large stocks offer higher returns
with less risk than the small stocks.6
For portfolios formed on the basis of valuation
ratios, those with negative ratios invariably had the
poorest performance with the lowest AMRs and

Table 1. Descriptive Statistics for Russell 2000 Stocks, July 1979–June 1997
Standard Coefficient of
Variable Mean Median Deviation Variation
Annual means
MVE 140.77a 108.34a 97.94a 0.70
P/E 32.13 32.33 9.65 0.30
P/S 15.38 11.87 9.90 0.64
M/B 4.35 4.04 1.65 0.38
Buy-and-hold annual return (%) 16.27 13.75 27.13 1.67
Cumulative annual return (%) 14.19 14.44 21.26 1.50
Average monthly return (%) 1.28 1.24 1.82 1.42

Annual medians
MVE 107.56a 78.45a 83.04a 0.77
P/E 14.97 15.51 4.06 0.27
P/S 0.86 0.78 0.35 0.41
M/B 1.74 1.74 0.41 0.24
Buy-and-hold annual return (%) 10.18 8.60 22.77 2.24
Cumulative annual return (%) 14.95 14.60 9.11 1.28
Average monthly return (%) 1.30 1.25 1.62 1.25
aIn millions of dollars.

62 Association for Investment Management and Research

 The Value Premium for Small-Capitalization Stocks

Table 2. Fundamental Characteristics and Returns of Various Portfolios, July

1979–June 1997
Annual Means of Equally Weighted Average
Mean Median of Monthly Returns
Number of Annual Standard Coefficient of
Portfolios Stocks Median Valuesa Mean Deviation Variation
MVE
Low 651 35.47 1.16% 2.00% 1.72
Medium 651 78.43 1.27 1.84 1.45
High 651 197.93 1.43 1.64 1.15

P/E
Negative 418 — 0.69% 2.13% 3.09
Low 513 9.46 1.65 1.58 0.96
Medium 514 15.51 1.44 1.67 1.16
High 513 32.91 1.21 2.18 1.80

P/S
Negative 59 — 0.53% 3.37% 6.36
Low 632 0.31 1.57 1.75 1.11
Medium 633 0.78 1.43 1.70 1.19
High 633 2.84 0.87 2.16 2.48

M/B
Negative 82 — 0.76% 2.92% 3.84
Low 625 0.99 1.51 1.58 1.05
Medium 626 1.74 1.39 1.69 1.22
High 625 3.98 0.96 2.30 2.40
aThe median of annual median values for MVE is in millions of dollars.

highest standard deviations, resulting in extremely
high coefficients of variation. Small-cap stocks with
negative earnings, sales, or book values are danger-
ous to portfolio health, and those with negative
sales are particularly toxic.
Value portfolios (made up of stocks with the
lowest but not negative valuation ratios) consis-
tently outperformed growth portfolios (stocks with
the highest ratios). Value portfolios also have lower
standard deviations and, as a result, coefficients of
variation that are 47–56 percent lower than the
coefficients of variation for growth portfolios.
The spread between the AMRs of value and
growth portfolios is 0.44 percentage points for P/E,
0.70 pps for P/S, and 0.55 pps for M/B. These dif-
ferences in spreads may be explained by two
(related) factors. First, the AMRs for the
highest-P/S (0.87 percent) and highest-M/B (0.96
percent) stocks are much lower than the AMR for
the highest-P/E stocks whereas the value portfo-
lios have a tighter range (1.51–1.65 percent). Sec-
ond, the relatively narrow spread for the P/E
portfolios appears to reflect the fact that, on aver-
age, there were far more companies with negative
P/E values (418) in the study than companies with
negative M/B values (82) or P/S values (59). There-
fore, many of the poorer performers are in the
negative-P/E group and relatively few are left in
the positive-P/E groups. This explanation is con-
sistent with the fact that the low-P/E portfolios had
higher returns than the low-P/S or low-M/B port-
folios and the high-P/E portfolios had higher
returns than the high-P/S and high-M/B portfo-
lios. Overall, these results suggest that among
small-cap companies, value stocks outperform
growth stocks for all three commonly used valua-
tion measures. The annual spread between value
and growth stocks (computed by multiplying the
monthly spread by 12) ranged from 5.28 pps for
P/E portfolios to 8.40 pps for P/S portfolios.
The AMRs of the value portfolios are 0.23–0.37
pps higher than the mean AMR of 1.28 percent for
the sample companies reported in Table 1, with
resulting annual spreads of 2.76–4.44 pps between
the value stocks and the total sample. The standard
deviations of the value portfolio AMRs are also
lower than the 1.82 percent standard deviation of
the total sample. The coefficients of variation of the
value portfolios are 22–32 percent lower than the
1.42 coefficient of variation for the total sample.
We carried out two-tailed t-tests for each year
in the study to determine the statistical significance
of the differences between the portfolio returns
observed in Table 2. Table 3 summarizes the
results. During the 18-year test period, large com-
panies had significantly higher AMRs than small

September/October 1999 63
Financial Analysts Journal

Table 3. Results of Two-Tailed t-Tests for Significant Differences between

Annual AMRs, July 1979–June 1997
Number of Years in Which Value Number of Years in Which Growth
Stocks Outperformed at Number of Years of Stocks Outperformed at
Portfolio Significance Levels of: No Significant Significance Levels of:
Basis 1% 2–5% 6–10% 10% Differencea 1% 2–5% 6–10% 10%
MVE 1 — 2 3 8 6 1 — 7
P/E 4 3 1 8 6 3 1 — 4
P/S 11 1 — 12 2 3 1 — 4
M/B 9 1 — 10 3 3 2 — 5
aAt the 10 percent level.

companies in 7 years, small companies had higher stocks with low valuations earned 0.35 pps more
AMRs in 3 years, and the returns of the two groups than the portfolio of stocks with medium valuations,
were not significantly different in 8 years. There- which in turn, earned 0.34 pps more than the port-
fore, the evidence of large companies outperform- folio of stocks with high valuations. In addition, the
ing small companies within the sample is weak. value portfolio had the lowest standard deviation
The evidence is stronger that value stocks earn whereas the growth portfolio had the highest stan-
higher returns than growth stocks. For example, dard deviation. Consequently, the value portfolio
among the portfolios based on P/S, the value stocks had the lowest and the growth portfolio had the
had significantly higher returns in 12 years and highest coefficient of variation.
growth stocks had higher returns in only 4 years. The superior performance of value stocks was
These results confirm that value stocks outper- not clustered in any particular period. Value stocks
formed growth stocks in the study period as mea-
sured by all three valuation measures.7 However,
the evidence of the value premium, in terms of both Table 4. Fundamental Characteristics,
return spread (Table 2) and statistical significance Returns, and Volatility of Combined
Portfolios, July 1979–June 1997
(Table 3), is strongest for the P/S-based portfolios
Variable Low Medium High
and weakest for the P/E-based portfolios. These
Medians of annual median values
findings for small-cap stocks are consistent with the
MVE ($ millions) 69.19 101.95 112.14
results for U.S. stocks in general—that is, that the P/E 8.15 14.66 32.14
market-to-book ratio is a better measure of value P/S 0.31 0.80 2.98
than the price-to-earnings ratio (Fama and French) M/B 0.96 1.85 4.91
and that the price-to-sales ratio is a better indicator
of value than market to book (Barbee et al.). Means of annual mean values
Number of stocks in portfolio 171 132 233
Combined Valuations. Next, we investigated AMR (%) 1.78 1.43 1.09
whether forming portfolios that combined the stocks Volatility of 18 annual mean values
with, respectively, low, medium, and high positive Standard deviation of AMR (%) 1.59 1.67 2.55
values of the three valuation ratios would improve Coefficient of variation of AMR 0.90 1.17 2.34
performance.8 The results are presented in Table 4.
Although size (MVE, in the top panel) was not a had higher returns in 11 of the 18 years, and growth
criterion for forming the portfolios, note that the stocks never had higher returns for more than 2
combined value portfolio (made up of stocks with years at a stretch. The AMRs of the value portfolio
consistently the lowest values for all three ratios) also exceeded those of the growth portfolio in three
had the lowest MVE and the combined growth port- six-year subperiods, by margins of 2.61 percent to
folio (stocks with consistently the highest values for 1.43 percent in 1979–1985, 1.12 percent to 0.57 per-
the three ratios) had the highest MVE, which indi- cent in 1985–1991, and 1.61 percent to 1.27 percent
cates that value stocks are generally smaller than in 1991–1997.
growth stocks within the small-cap universe.9 The These results contain several noteworthy
middle panel provides the number of stocks in the points. The coefficient of variation of the combined
combined portfolios and their returns.10 The com- value portfolio is lower than the coefficients of
bined value portfolio had the highest AMR; the com- variation of all the portfolios based on individual
bined growth portfolio had the lowest AMR. AMR valuation ratios in Table 2. The reason is that the
consistently increased with value; the portfolio of combined value portfolio has a higher AMR and

64 Association for Investment Management and Research


similar or lower standard deviation than the port-
folios based on individual valuation ratios. Thus,
combining the valuation ratios to identify value
stocks boosts returns without increasing risk. The
spread between the combined value and growth
portfolios is 0.69 pps, which is close to the highest
spread (0.70 pps) for the group based on P/S in
Table 2, but the coefficient of variation of 0.90 for
the combined value portfolio is much lower than
the coefficient of variation of 1.11 for the low-P/S
portfolio. The high premium for the combined
value portfolio is driven by high returns on value
stocks rather than low returns on growth stocks.
The combined growth portfolio had a higher AMR
than the growth portfolios based on P/S or M/B.
A comparison of Table 4 with Table 1 shows
that the combined value portfolio outperformed
the whole sample:
Combined Value
Performance Whole Sample Portfolio
Mean AMR (%) 1.28
Standard deviation (%) 1.82
Coefficient of variation 1.42
Note that the coefficient of variation for the value
portfolio is 37 percent lower than the coefficient of
variation of the sample. These findings demonstrate
that combining the valuation ratios to identify value
increases returns and improves the risk–return
characteristics of value portfolios formed from the
small-cap universe. The combined value portfolio
outperformed the sample companies by 0.50 pps a
month, or 6 pps a year, and had lower risk.
Because our results are based on equally
weighted returns, using value-weighted returns
might eliminate the value premium if the premium
is driven by high returns on small stocks. To exam-
ine this possibility, we computed value-weighted
returns for the combined value and growth portfo-
Table 5. Means of Equally Weighted AMRs of Combined Portfolios from
Whole Sample and from Sample Excluding Low-Liquidity Stocks:
Annually, January, and Annually without January, July 1979–June
1997
Period
All portfolio stocks
12 months (July–June)
January
11 months (excluding January)
Portfolios excluding stocks with price or dollar trading volume in the lowest decile
12 months (July–June)
January
11 months (excluding January)
September/October 1999
The Value Premium for Small-Capitalization Stocks
lios. The average annual value-weighted AMRs
were 1.83 percent for the value portfolio and 1.20
percent for the growth portfolio, compared with
their equally weighted AMRs of 1.78 percent for
value and 1.09 percent for growth. Therefore, the
value-weighted returns were higher than the
equally weighted returns but the spread for
value-weighted returns (0.63 pps) was only slightly
smaller than the spread for equally weighted
returns (0.69 pps). Evidently, the method of weight-
ing the returns does not materially influence the
results.
January and Liquidity Effects
I n v i e w o f L o u g h r a n ’ s fi n d i n g t h a t t h e
book-to-market effect is considerably reduced when
January returns and small growth companies are
excluded, we investigated whether small-cap stocks
offer a value premium outside the month of January
1.78 and examined the practical significance of this pre-
mium by determining whether it persists when illiq-
1.59
uid stocks are excluded from the sample.
0.90
As reported in Table 4, the 12-month AMRs
were 1.78 percent for the combined value portfolio
and 1.09 percent for the combined growth portfo-
lio, which would translate to aggregate annual
returns of 21.36 percent for value and 13.08 percent
for growth. The top panel of Table 5 shows the
AMRs for the combined portfolios for 12 months
(as in Table 4), for January, and for the 11
non-January months. The January returns account
for 22.38 percent of the annualized average
monthly returns for the value portfolio and 23.32
percent for growth. Therefore, both value and
growth stocks have disproportionately higher
returns in January than in the rest of the year.11 On
an annualized basis, however, the combined value
stocks outperformed the combined growth stocks
Difference
Value Growth (Value – Growth)
1.78% 1.09% 0.69pps
4.78 3.05 1.73
1.50 0.91 0.59
1.83 1.18 0.65
4.70 2.82 1.88
1.56 1.03 0.53
65
Financial Analysts Journal
by 8.28 pps, and although there was a sizable value
premium (1.73 pps) in January, most of the pre-
mium (6.55 pps) occurred outside January.
To investigate whether our results were driven
by liquidity effects, we tested for returns when
low-priced, thinly traded stocks were excluded
from the combined value and the combined growth
portfolios. We identified stocks in the lowest decile
of sample companies, based on either their stock
price at the end of June each year or their dollar
trading volume during the month of June each
year, and removed them from the portfolios.12 The
bottom panel of Table 5 shows that excluding these
illiquid stocks reduced the January returns but
increased the returns for the other 11 months,
resulting in slightly higher 12-month returns for
both the value and growth portfolios. The differ-
ence between the January AMRs of the value and
growth portfolios increased from 1.73 pps to 1.88
pps, whereas the difference in their 11-month
AMRs, excluding January, fell from 0.59 pps to 0.53
pps. The net result is a small decline in the differ-
ence between the 12-month AMRs of the two port-
folios (from 0.69 pps to 0.65 pps).
Results of t-tests for significant differences
between the AMRs of the combined value and
growth portfolios are in Table 6. For all stocks in
these portfolios, the 12-month and the January
AMRs were significantly higher for value stocks in
10 years and for growth stocks in 4 years; these
returns were not significantly different for the two
portfolios in the remaining 4 years. The 11-month
AMRs were significantly higher for value stocks in
nine years and for growth stocks in five years, with
no significant difference between the returns of the
two portfolios in four years. The frequency of sta-
tistically significant excess returns for value stocks
Table 6. Results of Two-Tailed t-Tests for Significant Differences between AMRs of Combined
Portfolios from Whole Sample and from Sample Excluding Low-Liquidity Stocks: Annually,
January, and Annually without January, July 1979–June 1997
Number of Years in Which Value
Stocks Outperformed at Significance
Levels of:
Period 1% 2–5% 6–10% 10%
All portfolio stocks
12 months (July–June) 8 1 1 10
January 5 5 — 10
11 months (excluding January) 7 2 — 9
Portfolios excluding stocks with price or dollar trading volume in the lowest decile
12 months (July–June) 7 1 1 9
January 4 4 1 9
11 months (excluding January) 7 1 1 9
aAt the 10 percent level.
66 Association for Investment Management and Research
was thus slightly higher in January than in the other
11 months, on average.
When the illiquid stocks were excluded, the
12-month AMRs and January returns were both
significantly higher for value stocks in nine years
and for growth stocks in four years; the returns of
these two portfolios were not significantly different
in five years. The non-January returns were signif-
icantly higher for value stocks in nine years and for
growth stocks in five years, with no significant
difference between the returns of the two portfolios
in four years. Therefore, removing the illiquid
stocks slightly lowered the frequency of statisti-
cally significant excess returns in January but did
not affect the significance of the non-January excess
returns. Overall, these results indicate that
small-cap stocks offer a value premium that is inde-
pendent of the January and liquidity effects.
Because annualized equally weighted AMRs
do not represent realistic returns for investors, we
computed value-weighted buy-and-hold annual
returns to measure the actual excess returns on
value stocks.13 For the 18-year test period, the com-
bined value and growth portfolios had mean BARs
of 22.73 percent and 17.24 percent, respectively;
that is, value stocks outperformed growth stocks by
5.49 pps a year. Excluding the illiquid stocks
slightly increased the mean BARs of the combined
portfolios to 23.09 percent for value and 17.67 per-
cent for growth, respectively, resulting in an excess
return of 5.42 pps on the value stocks. The mean
BAR of the liquid stocks in the combined value
portfolio was also 5.92 pps higher than the mean
return of the Russell 2000 (17.17 percent) for the
study period.14 Therefore, investors could have
earned a value premium of almost 6 pps on reason-
ably liquid small-cap stocks. The returns on these
Number of Years in Which Growth
Number of Years Stocks Outperformed at Significance
of No Significant Levels of:
Differencea 1% 2–5% 6–10% 10%
4 4 — — 4
4 3 1 — 4
4 5 — — 5
5 4 — — 4
5 2 1 1 4
4 5 — — 5

stocks exceeded the index returns in 12 of the 18
years, including excess returns of 5 pps or more in
10 years.
An interesting feature of these results is that
the mean BAR of 17.67 percent for the liquid stocks
in the combined growth portfolio is similar to the
mean BAR of 17.17 percent for the Russell 2000.
Therefore, investors do not have to short growth
stocks to earn the value premium. Simply buying
the combined value stocks offers a substantial pre-
mium over the index. The long-term performances
of the Russell 2000 and the liquid stocks in the
combined value and growth portfolios are depicted
in Figure 1, which shows the cumulative value at
the end of June 1997 of a dollar invested in these
value-weighted portfolios at the beginning of July
1979 and reinvested annually in the reconstituted
portfolios. Over the 18-year period, a dollar
invested in the combined value portfolio grew to
$31.36, compared with $11.94 for the Russell 2000
and $9.03 for the combined growth portfolio. The
combined value portfolio had a geometric average
annual return of 21.10 percent, 6.33 pps higher than
the 14.77 percent return of the Russell 2000 and 8.10
pps higher than the 13.00 percent return of the
combined growth portfolio.
Conclusions
Our findings indicate that among the small-cap uni-
Figure 1. Value of $1.00 Reinvested Annually in Russell 2000 and Liquid
Combined Value and Combined Growth Portfolios, July 1979–June
1997
35
30
25
Value ($)
20
15
10
5
0
7/79 7/81 7/83 7/85 7/87
September/October 1999
The Value Premium for Small-Capitalization Stocks
verse, value stocks outperform growth stocks
regardless of whether value is defined by P/E, P/S,
or M/B. Consistent with the combined results of
Barbee et al. and Fama and French for U.S. stocks in
general, we found that for small-cap stocks, P/S is
a better indicator of value than M/B, which, in turn,
is superior to P/E. However, value portfolios
formed on the basis of all three ratios provided the
best risk–return characteristics. These findings sug-
gest that combining the valuation ratios to identify
value stocks will increase investors’ returns and
improve the risk–return characteristics of value
portfolios.
Our results also show that most of the value
premium for small-cap stocks occurs outside Janu-
ary and that the premium is virtually unchanged
when low-liquidity stocks are excluded. A strategy
of investing in low-P/E, low-P/S, and low-M/B
stocks in the Russell 2000 beat the index by about 6
pps a year, on average.
We are grateful to George De Groot and Susy Dees of
Frank Russell Company and Brad Boppe, Michelle
Brown, Andy Halula, and Andy Heerse of Standard &
Poor’s Corporation for their assistance with the data for
this study. Professor Kim received partial funding from
the George Scull Fund through the University of Cin-
cinnati Foundation. Professor Mukherji was supported
by a summer research grant from the School of Business
of Howard University.
Liquid
Combined
Value
Russell 2000
Liquid Combined Growth
7/89 7/91 7/93 7/95 6/97
67
Financial Analysts Journal
Notes
1. We are not aware of any published fundamental analysis of
the stocks in the Russell 2000. Representatives of Frank
Russell Company, which compiles the index, indicated that
they too are unaware of any such study.
2. The percentage of index companies that could be identified
on the Compustat databases ranged from a low of 98.05
percent in 1992 to a high of 99.55 percent in 1993–1995.
Monthly returns were not available on the Compustat data-
bases for 22 of the identifiable index companies, so the test
sample consisted of, on average, 1,959 companies.
3. An additional advantage of using the AMR is that no adjust-
ment has to be made for stocks that do not have returns
available for the whole year. Only those months for which
returns are available are used to compute the AMR.
4. Market value of equity cannot be negative, of course, so we
have no negative MVE portfolio. P/S was negative for some
companies because its denominator is net sales (gross sales
less cash discounts, trade discounts, and returned sales and
allowances for which credit was given to customers).
5. Although the average number of identifiable index compa-
nies with return data available on Compustat was 1,959,
total numbers of companies in the portfolios are slightly
lower because of missing data. The number of companies
for which the required data were not available on Com-
pustat averaged six for MVE, two for P/S, and one each for
P/E and M/B. The average annual sample sizes in Table 2
thus range from 1,953 to 1,958 (97.65 percent to 97.90 percent
of the Russell 2000).
6. The higher returns of the larger stocks also indicate that our
results are not significantly affected by survivorship bias,
which would result in the smaller stocks showing higher
returns.
7. Although we report significance levels up to 10 percent,
most of the actual significance levels were 1 percent or 5
percent.
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