For decades, finance academics and professionals alike have debated the so-called “small-cap premium” — the idea that smaller companies have the potential to outperform larger ones, even after adjusting for their higher risk. Yet, as with many investing principles, time and data have refined our understanding. What does this mean for modern investors looking to benefit from small-cap opportunities?
Historical Insights and Challenges
The small-cap premium concept, first highlighted by Zurich-based researcher Rolf Banz in 1981, suggested that smaller firms consistently outperformed larger peers on average returns.[1] For years, data supported this view: the S&P 500’s lackluster performance from 2000 to 2010 contrasted sharply with the positive annual returns delivered by the Russell 2000 index of smaller companies.
However, the story has since evolved. Analysis of longer-term data reveals that the performance advantage Banz observed may not have been as robust as initially thought. Critics argue that the original analysis included survivorship bias, excluding companies that performed poorly enough to be delisted from exchanges. When accounting for such factors, the “pure size effect” appears less definitive.[2]
A Refined Lens: Filtering for Quality
Recent research proposes a more nuanced view: rather than dismissing the small-cap premium, it may be more effective to focus on quality within the small-cap space.[3] This refined approach involves excluding so-called “junk” stocks — those that exhibit excessive volatility, low profitability, or overpricing. When filtering out these factors, studies show that small-cap stocks can deliver strong returns without the added volatility often associated with the segment.
Our Approach to Small-Cap Opportunities
At Petiole Asset Management AG, we do not invest in small caps simply because they are small; instead, we apply a rigorous selection process, filtering for criteria such as profitability, intrinsic value, and low volatility. This disciplined approach aligns with the latest academic research, which we actively incorporate into our screening process. Leveraging our two decades of industry experience and deep sector insights, we focus on identifying mature, late-stage companies with solid growth fundamentals that align with our clients’ long-term objectives. Only a small fraction — approximately 4% — of the firms we analyze pass our comprehensive selection process, ensuring a high standard of quality across our diversified portfolios.
[1] Journal of Financial Economics
[2] Journal of Portfolio Management
[3] Journal of Financial Economics
