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The searchers for stock market pricing inefficiency seemed to be on firm ground when examining smaller firms. The problem is that the ground is firm most of the time, but has long periods when it is downright dangerous.
Early results
A number of studies in the 1980s found that smaller firms’ shares outperformed those of larger firms over a period of several decades (the small firm effect, small-capitalisation, or small-cap effects). This was found to be the case in the USA, Canada, Australia, Belgium, Finland, the Netherlands, France, Germany, Japan and Britain (key studies in the area are Banz (1981), Reinganum (1981), Keim (1983), Fama and French (1992), Dimson, et al. (2002) and the annual Hoare Govett Smaller Companies Index reports).
Dimson and Marsh (1986) put the outperformance of small UK firms’ shares at just under 6% per year. These studies caused quite a stir in both the academic and the share-investing communities.
Why this result?
Some rational explanations for this outperformance were offered: for example, perhaps the researchers had not adequately allowed for the extra risk of small shares.
There is a particular risk associated with lower liquidity. That is, you just can’t sell even a modest quantity of shares to close your position without moving the price – something I find quite a frustration with companies I buy with markets capitalisations under £30m and small free floats.
Most of these academic studies used beta risk as their measure, i.e. the degree to which the share goes up or down when the market moves. The results generally show lower betas for small companies, so that is not the explanation for small firms’ out-performance. (There are now severe doubts about beta’s ability to capture risk-return relationships – I don’t give it any heed).
Another explanation is that it is proportionately more expensive to trade in small companies’ shares: if transaction costs are included, the net return of trading in small company shares comes down. But this does not explain the outperformance of a portfolio bought and held for a long period.
There is also the issue of ‘institutional neglect’, by which analysts fail to spend enough time studying small firms, preferring to concentrate on the larger 100 or so. This may open up opportunities for the smaller investor who is prepared to conduct a more detailed analysis of those companies to which inadequate professional attention is paid.
The excitement fades
The interest in small companies’ shares in the 1980s and 1990s was much greater among investors and their advisers than in academe, but it was to end in tears.
Investors who rushed to exploit this small firm effect had their fingers burnt. As The Economist put it: ‘The supposedly inefficient market promptly took its revenge, efficiently parting investors from their money by treating owners of small stocks to seven years of under-performance.’ This article refers to the US market but similar underperformance occurred on both the US and UK markets.
UK studies by Dimson, Marsh and Staunton (Dimson and Marsh 1999, Dimson et al., 2001, 2002) showed that smaller companies outperformed large companies by 5.2% pa between 1955 and 1988 (by 4.5% for small companies and 9.0% for very small (micro) companies).
However, in the period 1989 to 1998 the return premium in favour of small companies went into reverse: large companies produced a return 7.0% greater than small companies and 10.5% for micro capitalisation companies.
Over in the US, until the mid-1980s small companies out-performed by 2.2%, with micro companies out-performing by 3.9%.
Then, in the period 1984-1998, large companies did better than small by 2.8%, with micro companies underperforming by 6.4%.
The researchers show this kind of reversal occurred in many different countries in the late 1980s and 1990s. Some people say that what happened was that following the early 1980s’ academic studies so many funds were set up to buy small firms’ shares that in 1986 and 1987 their prices were pushed up to unsustainable levels (they had 10 years of outperformance pushed into two).
Up-to-date evidence
The Credit Suisse Global Investment Returns Yearbook 2017, written………………..
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