The existence of the size premium has been challenged in recent years. But a new working paper says that a “robust” size premium can be observed after controlling for firm quality.

Control your junk: The size premium, or size effect, is based on empirical evidence that smaller listed firms tend to have higher returns than larger firms over long time periods. The dominant theory explaining these observations is that stocks of smaller firms outperform because they are riskier than larger firms. The authors of the new paper contend that previous evidence on the variability of the size effect is largely due to the volatile performance of “junk” firms, which are unprofitable, stagnant, or poorly managed companies. “Controlling for junk, a much stronger and more stable size premium emerges that is robust across time,” say the authors.

This new research confirms that the size premium is conditional and that it is more complex than the simple notion that smaller firms have higher returns than larger ones. Coincidentally, as this new research was being released, Business Valuation Update released an interview with Michael A. Crain (The Financial Valuation Group), who discussed his own research on the size premium. Crain has also found that the premium exists in listed firms but under certain conditions.

Contrary to theory: “The new paper acknowledges that the size premium diminished or disappeared in the 1980s and 1990s after Rolf Banz first documented it, which triggered important questions about this phenomenon,” Crain tells BVWire. “This study claims that the premium can still be observed conditionally during this period by controlling for the quality of firms. In short, the components of quality are profitability, profit growth, safety, and payout. The research also finds that smaller listed firms tend to be ‘junky’ and larger listed firms tend to be quality. Contrary to risk-based theory, the study finds junky firms (presumably riskier) do not generate higher returns and instead quality firms seem to drive higher expected returns.”

The new paper is titled “Size Matters, if You Control Your Junk,” from AQR Capital Management LLC and researchers from New York University and the University of Chicago. The Crain interview is in the February 2015 issue of Business Valuation Update (subscription required).