Morningstar Advisor - August/September 2009 - 39

Exhibit 3: Small-Value Premium Doesn’t Exist Like value over growth, small-value stocks failed to significantly outperform small-growth stocks. 50% 40 30 20 10 0 –10 –20 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 expected value premium of zero in the year after maximum economic decline. The shaded regions show a wide spread, meaning that value has sometimes greatly underperformed and outperformed, but average returns for value versus growth were a dead heat. What about Russell’s research? As mentioned earlier, the short history of Russell’s indexes only includes four recessions. Those recessions happen to include one of the biggest outperformances we found by value on the way out of the economic doldrums. Twelve months from the inflection point of the 2001 recession, represented in Exhibit 3 by the top edge of the lighter region, small value returned an incredible 40% premium over small growth. This outperformance should come as no surprise, given that the 2001 recession occurred when the growth-driven dot-com bubble burst, sparking several years of high returns for value and small caps. Because the Russell research looked at the average returns over the four recessions it examined, this massive outlier exerted a huge pull on the results, making a one-off oddity look like a significant pattern in stock market returns. A final note on value stocks’ returns after a recession: Notice the upturns in typical cumulative returns that can be seen in both the broad market and small-cap charts near month 13. Rather than an unusual premium for value stocks when the economy begins growing once again, these upturns actually represent a return to normality. Value stocks tend to produce higher returns than do other stocks on average—the average monthly value premium is 0.4%—so the most unexpected finding in these charts is actually the lack of outperformance by value stocks seen through the latter half of a recession. Size Matters—A Lot Chart shows the cumulative returns of small-value stocks over small-growth for 18 months after the middle of 11 recessions. Middle line is the median. Shaded areas show range of 11 recessions. (Best and worst returns not shown.) Exhibit 4: But Small-Cap Premium Is Real After the inflection point of recessions, small-cap companies strongly outperformed large caps. 30% 25 20 15 10 5 0 –5 –10 0 1 2 3 4 5 6 7 8 9 10 11 12 13 14 15 16 17 18 Chart shows the cumulative returns of small caps over large caps for 18 months after the middle of 11 recessions. Middle line is the median. Shaded areas show range of 11 recessions. (Best and worst recession returns not shown.) The research by Russell did get something right. Small caps are absolutely the place to be when the recession begins to turn around. MorningstarAdvisor.com 39

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Morningstar Advisor - August/September 2009

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