Small cap

The name ‘small cap’ refers to a company’s capitalization as determined by the total market value of its publicly traded shares. Small cap stocks are generally defined as the stock of publicly traded companies that have a market capitalization ranging from $300 million to about $2 billion. Small cap stocks are believed to offer better performance explained by investors’ lack of knowledge about their growth potential and lack of institutional interest. From 1928 through 2016, the S&P 500 index compounded at 9.7%, while small-cap value stocks grew at 13.5%. Higher returns bring about higher risk, however it is not too far from the S&P500 and the increased risk can be weathered by long term investors.

The finding that size is related to expected returns dates back at least to Banz (1981), who found that small stocks in the U.S. (those with lower market capitalizations) have higher average returns than large stocks, a relation which is not accounted for by market beta. This was followed by a host of publications (e.g., Roll (1981), Reinganum (1981), Christie and Hertzel (1981), Schwert (1983), Blume and Stambaugh (1983), Chan et al. (1985), Huberman and Kandel (1987), Chan and Chen (1988)), culminating with the famous Fama & French paper Fama and French (1993) where the size premium was minted into a fundamental “risk factor”, alongside with the Market factor and the Value factor.

The relation between size and returns is important for several reasons. First, the small cap premium has become one of the focal points for discussions of market efficiency. Second, the size factor has become one of the staples of current asset pricing models used in the literature (e.g., Fama and French (1993, 2014)). Third, the size effect implies that small firms face larger costs of capital than large firms, with important implications for corporate finance, incentives to merge and form conglomerates, and broader industry dynamics. Fourth, the size effect has had a large impact on investment practice, including spawning an entire category of investment funds, giving rise to indices, and serving as a cornerstone for mutual fund classification.

Chan, Chen, and Hsieh (1985) were among first to suggest that a small cap premium isn’t stable over time but intensively fluctuates. Herskovic, Kind, Kung, (2018) document that the observed time-varying dispersion in firm-specific productivity can account for a large size premium in the 1960’s and 1970’s, the disappearance in the 1980’s and 1990’s, and re-emergence in the 2000’s. Zakamulin (2013) models time varying small stock premium using lagged economic variables such as the stock market return, dividend yield on the stock market, the Fama-French and the Jegadeesh-Titman factors, default spread, T-bill return, term premium, and inflation rate. Using this model, Zakamulin is able to predict small stock premium one to 12 months ahead, generating statistically significant alpha due to behavioural rather than risk factors.

The source of the small stock premium has been the subject of considerable debate in financial economics. Several competing explanations for this size premium have been proposed. Most of the investigations regarding this topic contend that the size premium represents the investors’ compensation for bearing greater systematic risk (see, among others, Chan, Chen, and Hsieh (1985), Fama and French (1993), and Vassalou and Xing (2004)). The non-risk-based explanations are as follows. Stoll and Whaley (1983) and Pastor and Stambaugh (2003) observe that relative to stocks of larger firms, small stocks demonstrate lower liquidity and therefore involve higher transaction costs. Thus, the size premium may represent the investor’s compensation for the lower liquidity of small stocks. Kothari, Shanken, and Sloan (1995) and Shumway and Warther (1999) conjecture that survivorship bias (which can also be characterized as delisting bias) is the main source of the size premium. Hou and Moskowitz (2005) argue that market frictions are the source of the size premium. In particular, these authors examine the average delay with which a firm’s stock price responds to information and demonstrate that this price delay captures a substantial portion of the size premium. A possible behavioural explanation for the size effect, based on disagreement and differences in investors’ tastes, is presented by Fama and French (2007).

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