Small Firm Effect

What Is the Small Firm Effect?

The small firm effect is a theory that predicts that smaller firms, or those companies with a small market capitalization, tend to outperform larger companies.

The small firm effect is an apparent market anomaly used to explain superior returns in Gene Fama and Kenneth French's Three-Factor Model, with the three factors being the market return, companies with high book-to-market values, and small stock capitalization.

Is the small firm effect real? Of course, verification of this phenomenon is subject to some time period bias. The time period examined when looking for instances in which small-cap stocks outperform large-caps largely influences whether the researcher will find any instance of the small firm effect. At times, the small firm effect is used as a rationale for the higher fees that are often charged by fund companies for small-cap funds.

Understanding the Small Firm Effect

Publicly traded companies are classified into three categories: large-cap ($10 billion +), mid-cap ($2-$10 billion), and small-cap (< $2 billion). Most small-capitalization firms are startups or relatively young companies with high-growth potential. Within this class of stocks, there are even smaller classifications: micro-cap ($50 million - $2 billion) and nano-cap (<$50 million).

The small firm effect theory holds that smaller companies have a greater amount of growth opportunities than larger companies. Small-cap companies also tend to have a more volatile business environment, and the correction of problems — such as the correction of a funding deficiency — can lead to a large price appreciation.

Finally, small-cap stocks tend to have lower stock prices, and these lower prices mean that price appreciations tend to be larger than those found among large-cap stocks. Tagging onto the small firm effect is the January effect, which refers to the stock price pattern exhibited by small-cap stocks in late December and early January. Generally, these stocks rise during that period, making small-cap funds even more attractive to investors.

The small firm effect is not foolproof as large-cap stocks generally outperform small-cap stocks during recessions.

Small Firm Effect vs. the Neglected Firm Effect

The small firm effect is often confused with the neglected firm effect. The neglected firm effect theorizes that publicly traded companies that are not followed closely by analysts tend to outperform those that receive attention or are scrutinized. The small firm effect and the neglected firm effect are not mutually exclusive. Some small-cap companies may be ignored by analysts, and so both theories can apply.

Advantages and Disadvantages of Small Firms

Small-cap stocks tend to be more volatile than large-cap funds, but they potentially offer the greatest return. Small-cap companies have more room to grow than their larger counterparts. For example, it's easier for cloud computing company Appian (APPN) to double, or even triple, in size than Microsoft.

On the other hand, it's much easier for a small-cap company to become insolvent than a large-cap company. Using the previous example, Microsoft has plenty of capital, a strong business model, and an even stronger brand, making it less susceptible to failure than small firms with none of those attributes.