The record on small companies: A review of the evidence

It is now exactly 20 years since the publication of the two pioneering papers — Banz, R. (1981) ‘The Relationship between Return and Market Value of Common Stock’, Journal of Financial Economics, 9, 3–18, and Reinganum, M. (1981) ‘Misspecification of Capital Asset Pricing: Empirical Anomalies Based on Earnings’ Yields and Market Values', Journal of Financial Economics, 9, 19–46 — on the performance of small capitalisation companies. The discovery of the so-called ‘small size effect’ generated a lively debate on market efficiency and asset pricing and led to a considerable amount of further research that shed light on the nature and market behaviour of this important asset class. The purpose of this paper is to review the empirical evidence on small companies with particular emphasis on the implications relevant to practising fund managers. The weight of the evidence suggests that conventional risk measures (betas) fail to reflect the inherent risks of small firms. Such firms are, however, riskier in terms of higher mortality, lower liquidity, higher short-term borrowings and higher volatility of earnings. The evidence also suggests that the outperformance of small cap stocks, even at the pinnacle of its manifestation, was driven by a relatively limited number of such stocks. Such good performers possess a number of key characteristics. They have lower than average market-to-book and price-earnings ratings, and their market value is higher than the average capitalisation of the small cap sector; they have been listed in the market for longer than a year and have not raised additional equity capital in the last year. They have reasonably stable earnings growth profile, do not belong to sectors with excessive swings in analyst forecasts and current ratings do not depend on hugely over-optimistic analyst forecasts.