Migration

Migration of stocks across size and value portfolios contributes to the size and value premiums in average stock returns. The size premium is almost entirely generated by the small-capitalization stocks that earn extreme positive returns and thus become big-cap stocks. The value premium comes from (1) value stocks that improve in type because their companies are acquired by other companies or because they earn high returns and migrate to a neutral or growth portfolio, (2) growth stocks that earn low returns and thus move to a neutral or value portfolio, and (3) the slightly higher returns on value stocks that do not migrate compared with the returns on growth stocks that do not migrate.We examine a breakdown of average returns focused directly on migration. At the end of each June for 1926 through 2005, we form six value-weight portfolios on size (market capitalization) and price-to-book ratio (P/B). We then split each portfolio into four migration groups: Same (stocks that stay in the same portfolio when portfolios are rebalanced annually), dSize (small-cap stocks that become big-cap stocks and big-cap stocks that become small-cap stocks), Plus (stocks that move toward growth or are acquired by another company), and Minus (stocks that move toward value, that are delisted for cause, or whose book equity goes negative). We examine how much each group contributes to excess returns for the six portfolios.A migration group’s contribution to a portfolio’s excess return depends on both the group’s excess return and its weight in the portfolio. For example, a group return close to the market return contributes little to a portfolio’s excess return even when the group is a large share of the portfolio. Conversely, a group with a high excess return may not have much effect on a portfolio’s excess return if the group has little weight in the portfolio.Size premium. The higher average returns of small-cap stocks are primarily a result of one type of migration: small-cap stocks that become big. Specifically, price appreciation moves a stock’s market cap from below to above the NYSE median from one year to the next. Big-cap stocks that become small have strong negative average excess returns, but they contribute little to the size premium. This perhaps surprising result arises because, unlike stocks that move from small to big, stocks that become small account for tiny fractions of the market capitalization of big-cap portfolios. Small- and big-cap stocks that improve in type from one year to the next (move toward growth or merge into other firms) have high average excess returns, but improvements in type make similar contributions to small- and big-cap stock returns. As a result, they are a minor factor in the size premium. Stocks that deteriorate in type or stay in the same portfolio from one year to the next actually lean against the size premium; that is, they contribute more to returns on portfolios of big-cap stocks. In the end, the size premium in average returns for 1927–2006 traces almost entirely to the high average excess returns (more than 50 percent) earned by the 8–12 percent of the market capitalization of small-cap stocks that moves to a big-cap portfolio from one year to the next.Value premium. Three of the four migration groups (Same, Plus, and Minus) contribute to the value premiums in the average returns of 1927–2006. Stocks that stay in the same portfolio from one year to the next contribute a modest 1.0 percent (or 1 percentage point) to the value premium for small-cap stocks and 1.7 percent to the premium for big-cap stocks. These contributions to the value premium trace to the fact that value stocks that do not migrate have higher average returns than growth stocks that do not migrate.In contrast, differences in transition frequencies for value and growth stocks largely drive the contributions of Plus and Minus migration to value premiums. Without changing size groups, there is little room for growth stocks to improve in type or for value stocks to deteriorate. Thus, Plus transitions are common for value stocks but rare for growth stocks, and Minus transitions are common for growth stocks but rare for value stocks. As a result, Plus transitions, which are accompanied by high returns, contribute about 3.5 percent (3.5 percentage points) more per year to the excess returns of small-cap and big-cap value portfolios than they do to the matching growth portfolios. Similarly, Minus transitions and their low returns are a bigger drag on the excess returns of growth portfolios. The impact is particularly large for the spread between small-cap value and small-cap growth returns. Minus transitions contribute 5.1 percent per year to the 1927–2006 small-cap value premium, versus 1.2 percent for big-cap stocks.One type of migration acts to lower the small-cap value premium. Small-cap value and growth stocks have high returns when they move to a big-cap portfolio; the 1927–2006 average excess returns exceed 60 percent per year and are about the same for growth and value stocks. But migration to a big-cap portfolio from one year to the next is more common among small-cap growth stocks (on average, 11.8 percent of market cap) than among small-value stocks (8.5 percent). As a result, moves from small to big add 2.9 percent per year more to the average return on the small-cap growth portfolio and so work against the value premium.