The size effect, also called the small cap effect, is the tendency of small cap shares to outperform large caps over the long term. Evidence for this looks less good than it once did.
The size effect can be explained by the illiquidity of small companies, particularly as a result of higher trading costs (e.g., because of higher spreads).
The extent of the small cap effect has varied over time, with quite long periods of over-performance and under-performance compared to large caps, which makes it difficult to assemble enough data to provide a definitive proof or disproof.
Given that the biggest weakness strategies using the small cap effect is that the real out-performance is likely to be offset by trading costs, perhaps the best advice to investors is to regard it as most relevant when constructing a portfolio of shares that they are likely to hold for the long term. (http://moneyterms.co.uk/size-effect/)
Stock Markets and The Size Effect
There's real value in understanding market capitalization!
Large-cap, small-cap and mid-cap stocks all perform differently, and their sizes change. That's why you need to follow market capitalization -- the total value the stock market places on a company.
Market capitalization refers to the total value the market puts on a company. It's calculated by multiplying the price of a stock by its total number of shares.
So the concept of market capitalization is straightforward and pretty simple to grasp. The reason you want to know about it is that different sized companies perform differently. The details of how that happens, though, are not so clear.
Many studies have shown that small firms (capitalization or assets) tend to outperform large ones. Other studies have argued that it is not the size that matters, but it is the attention and number of analysts that follow the stock.
Anyway, "The Size Effect" is subject to intense debate over whether an opportunity to generate excess returns actually exists, or that its not reasonable to assume that investors can realize those returns.
Small stocks typically have large spreads, thus providing large trading opportunities. On the other hand, it is not easy to be bought by institutional managers without significantly affecting the share price.
Therefore, even so called "small company" funds have difficulty taking advantage of small capitalization stocks. The point being that you couldn't really buy them in large quantities, if at all, at their quoted price.
More comprehensively on introduction about size effect, please download this paper:
RD Coleman - 1997 - numeraire.com
31 October 1997
31 October 1997
First Submitted: 13 June 1995
Current Draft: 31 October
by JB Berk - 1995
Important Papers
1. BERK, J.B., 1995. A critique of size-related anomalies. Review of Financial Studies.
2. KNEZ, P.J. and M.J. READY, 1997. On the robustness of size and book-to-market in crosssectional regressions. Journal of Finance.
3. LAMOUREUX, C.G. and G.C. SANGER, 1989. Firm size and turn-of-the-year effects in the OTC/NASDAQ market. Journal of Finance.
4. HERRERA, M.J. and L.J. LOCKWOOD, 1994. The size effect in the Mexican stock market. J. BANKING FINANCE.
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- ALESINA, A., R. WACZIARG and M.P. PAGE, 1998. Openness, country size and government. Journal of Public Economics.
- ANDERSON, Don, Andrea HAYNES and Richard HEANEY, Company Takeovers and Equity Returns: The Target Size Effect
- BARRY, C.B., et al., 2002. Robustness of size and value effects in emerging equity markets, 1985-2000. Emerging Markets Review.
- BERK, J.B., 1995. A critique of size-related anomalies. Review of Financial Studies.
- BERNARD, V., J. THOMAS and J. WAHLEN, 1997. Accounting-based stock price anomalies: Separating market inefficiencies from risk. Contemporary Accounting Research.
- BRACONIER, H. and K. EKHOLM, 2002. Competition for Multinational Activity in Europe: The Role Played by Wages and Market Size.
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- COLEMAN, R. D., 1997. http://www.numeraire.com/download/history.pdf
- COLWELL, P.F. and H.Y. PARK, 1990. Seasonality and size effects: The case of real-estate-related investment. The Journal of Real Estate Finance and Economics.
- DAMODARAN, A., 1989. The weekend effect in information releases: a study of earnings and dividend announcements. Review of Financial Studies.
- DANIEL, Kent and Sheridan TITMAN, Evidence on the Characteristics of Cross Sectional Variation in Stock Returns
- DAVIS, James, Eugene F. FAMA, and Kenneth R. FRENCH, Characteristics, Covariances, and Average Returns: 1929-1997
- De GIORGI, Enrico, Thorsten HENS and Thierry POST, 2005. Prospect Theory and the Size and Value Premium Puzzles
- EGGERT, W. and M. KOLMAR, 2004. Contests with Size Effects.
- FAMA, E.F. and K.R. FRENCH, 1998. Market efficiency, long-term returns, and behavioral finance. Journal of Financial Economics.
- FAMA, Eugene F. and Kenneth R. FRENCH, Permanent and Temporary Components of Stock Prices
- FRANKEL, R. and C.M.C. LEE, 1998. Accounting valuation, market expectation, and cross-sectional stock returns. Journal of Accounting and Economics.
- GLOSTEN, L.R. and P.R. MILGROM, 1984. Bid, ask and transaction prices in a specialist market with heterogeneously informed traders.
- GUTIERREZ, R., 2001. Book-to-market equity, size, and the segmentation of the stock and bond markets.
- HALL, B.H., 1986. The relationship between firm size and firm growth in the US manufacturing center.
- HERRERA, M.J. and L.J. LOCKWOOD, 1994. The size effect in the Mexican stock market. J. BANKING FINANCE.
- HONG, Harrison, Terence LIM and Jeremy C. STEIN, Bad News Travels Slowly: Size, Analyst Coverage, and the Profitability of Momentum Strategies
- JAGANNATHAN, R., K. KUBOTA and H. TAKEHARA, 1998. … Between Labor-Income Risk and Average Return: Empirical Evidence from the Japanese Stock Market. Journal of Business.
- JAUMOTTE, F., 2004. Foreign direct investment and regional trade agreements: the market size effect revisited.
- JEGADEESH, N., 1992. Does market risk really explain the size effect. Journal of Financial and Quantitative Analysis.
- JEGADEESH, Narasimhan, Does Market Risk Really Explain the Size Effect?
- KANG, J.K. and R. STULZ, 1997. Why is there a home bias. An analysis of foreign portfolio equity.
- KEIM, D.B. and A. MADHAVAN, 1996. The upstairs market for large-block transactions: analysis and measurement of price effects. Review of Financial Studies.
- KNEZ, P.J. and M.J. READY, 1997. On the robustness of size and book-to-market in crosssectional regressions. Journal of Finance.
- KONINGS, J., H. LEHMANN and M.E. SCHAFFER, 1996. Job creation and job destruction in a transition economy: ownership, firm size, and gross job flows ….
- KRASHINSKY, H., 2002. Evidence on Adverse Selection and Establishment Size In the Labor Market.. Industrial and Labor Relations Review 56 (1): 84.
- LAMOUREUX, C.G. and G.C. SANGER, 1989. Firm size and turn-of-the-year effects in the OTC/NASDAQ market. Journal of Finance.
- LOUGHRAN, T. and J.R. RITTER, 2000. Uniformly least powerful tests of market efficiency. Journal of Financial Economics.
- MALKIEL, B.G., 2003. The Efficient Market Hypothesis and Its Critics. Journal of Economic Perspectives.
- MARTIN, P.J. and H. REY, 2001. Financial super-markets: size matters for asset trade.
- MELITZ, M. and G.I.P. OTTAVIANO, 2003. Market Size, Trade, and Productivity. Harvard University, mimeograph.
- MERTON, R.C. and C. ROBERT, 1987. A simple model of capital market equilibrium with incomplete information. Journal of Finance.
- MITCHELL, W., 1991. Dual clocks: Entry order influences on incumbent and newcomer market share and survival when …. Strategic Management Journal.
- PODOLNY, J.M., 2001. Networks as the Pipes and Prisms of the Market. American Journal of Sociology.
- RAEDY, J., 2000. A reconciliation of stock market anomalies.
- REINGANUM, Marc R., A Direct Test of Roll's Conjecture on the Firm Size Effect
- SCHWERT, G.W. and M.P. PAGE, 2002. Anomalies and market efficiency.
- SKERRATT, Len, Contrarian investment strategies using financial ratios
- VLIET, W. N. van, 'Investment Strategies and Real Option Theory'
- WIGNARAJA, G., 2002. Firm Size, Technological Capabilities and Market-oriented Policies in Mauritius. Oxford Development Studies.
- WINTER-EBMER, R. and J. ZWEIMUELLER, 1999. Firm Size Wage Differentials in Switzerland: Evidence from Job Changers. American Economic Review (Papers and Proceedings).
- ZAROWIN, Paul, 1990 Size, Seasonality, and Stock Market Overreaction, The Journal of Financial and Quantitative Analysis, Vol. 25, No. 1. (Mar., 1990), pp. 113-125.
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