It’s been 17 years since the professors Eugene Fama and Ken French penned the first of several papers that identified small-cap value as a separate equity beta worthy of special consideration. The basic idea is that stocks that are generally shunned by the crowd, as indicated by a low price-to-book ratio, are riskier than the market overall. Investors who are willing and able to hold this risk are rewarded with above-average returns in the long run.
There are a number of theories for why small-cap value stocks generate returns that are higher than implied by the standard interpretation of modern portfolio theory. One idea is that small-cap value is a proxy for the risk tied to the economic cycle. During recessions, small-cap value shares are especially vulnerable and so investors are especially keen to shun this group. In turn, the fear generates an above-average expected return for small-cap value.