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What is the small business effect?

The Small Company Effect is a theory that predicts that small companies, or companies with small market caps, tend to outperform large 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, the three factors being market return, firms with book-to-market values high and a small market capitalization.

Is the small business effect real? Of course, verification of this phenomenon is subject to some period bias. The time period examined when searching for instances in which small-cap stocks outperform large-cap stocks largely influences whether the researcher will find an instance of the small-company effect. Sometimes the small business effect is used as a justification for the higher fees often charged by fund companies for small cap funds.

Key points to remember

  • The small firm effect theory posits that small firms with low market capitalizations tend to outperform large firms.
  • The argument is that small companies are generally more agile and able to grow much faster than larger companies.
  • Small cap stocks also tend to be more volatile and riskier for investors than large cap stocks.

Understanding the Small Business Effect

Publicly traded companies are classified into three categories: large cap ($10 billion+), mid cap ($2 to $10 billion), and small cap (<$2 billion). Most small cap companies 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 business effect theory holds that small businesses have more growth opportunities than large businesses. Small-cap companies also tend to have a more volatile trading environment, and correcting issues, such as correcting a funding shortfall, can lead to sharp 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 seen among large cap stocks. The January effect is in addition to the small company effect, which refers to the stock price pattern exhibited by small cap stocks in late December and early January. Typically, these stocks rise during this period, making small cap funds even more attractive to investors.

The small-company effect is not foolproof, as large-cap stocks typically outperform small-cap stocks during recessions.

Small firm effect versus 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 scrutiny. The small firm effect and the neglected firm effect are not mutually exclusive. Some small-cap companies may be overlooked by analysts, so both theories may apply.

Advantages and disadvantages of small businesses

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

On the other hand, it is 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 likely to fail than smaller companies without any of these attributes.

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