Small Firm Effect

What is the 'Small Firm Effect'

A theory that holds that smaller firms, or those companies with a small market capitalization, outperform larger companies. This market anomaly is a factor used to explain superior returns in the Three Factor Model, created by Gene Fama and Kenneth French - the three factors being the market return, companies with high book-to-market values, and small stock capitalization.

BREAKING DOWN 'Small Firm Effect'

The 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.

RELATED TERMS
  1. Small-Value Stock

    A description of stock where the underlying company has a small ...
  2. Mid Cap

    A company with a market capitalization between $2 and $10 billion.
  3. Neglected Firm Effect

    A theory that explains the tendency for certain lesser-known ...
  4. Nasdaq SmallCap Market

    The Nasdaq equity market for companies that have relatively small ...
  5. Factor Investing

    An investment strategy in which securities are chosen based on ...
  6. Capital Markets

    Capital markets are markets for buying and selling equity and ...
Related Articles
  1. Investing Basics

    Explaining the Fama and French Three-Factor Model

    The Fama and French three-factor model expands on the CAPM to provide a more thorough tool that measures portfolio performance and predicts future returns.
  2. Investing

    Small Cap Investing: How to Think About Illiquidity

    Do your homework, have a long term view, exercise patience, you'll find that investing in small market capitalization stocks is no riskier than investing in large stocks
  3. Investing Basics

    Six Market Anomalies Investors Should Know

    Certain tradable anomalies persist in the stock market. Here are six that fascinate investors.
  4. Trading Strategies

    Small Caps Boast Big Advantages

    Find out why little companies have the greatest potential for growth.
  5. Stock Analysis

    The Rally In Small-Cap Growth Stocks

    Small caps have been improving along with the economy. Investors should look into adding these shares to their portfolio.
  6. Bonds & Fixed Income

    Achieving Better Returns In Your Portfolio

    We look at three risk factors that best explain the bulk of equity performance.
  7. Active Trading Fundamentals

    Behavioral Finance: Anomalies

    By Albert PhungThe presence of regularly occurring anomalies in conventional economic theory was a big contributor to the formation of behavioral finance. These so-called anomalies, and their ...
  8. Mutual Funds & ETFs

    Valuing Large-Cap Stocks

    Investors seeking to preserve capital in volatile markets might want to consider large-cap stocks.
  9. Investing

    A New Reason Behind This Strategy’s Outperformance

    One of the great anomalies of investing: The historical long-term outperformance of smart beta or factor-based strategies relative to the equity market.
  10. Fundamental Analysis

    7 Controversial Investing Theories

    We take a closer look at the theories that attempt to explain and influence the market.
RELATED FAQS
  1. What are the alternatives to book-to-market ratio analysis?

    Read about some of the common alternatives to book-to-market ratio that fundamental investors can use to value a publicly ... Read Answer >>
  2. Why is the P/E ratio a better metric than book-to-market ratio analysis?

    Read about the most popular company valuation metric, Price-to-Earnings, and how it compares to the lesser-used book-to-market ... Read Answer >>
  3. What is the difference between book-to-market ratio and cash flow to price?

    Learn about the differences between the book-to-market ratio and cash-flow-to-price ratio, as well as in which contexts investors ... Read Answer >>
  4. Does investing in small cap stocks have advantages over investing in big cap stocks?

    Learn about the advantages of investing in small-cap stocks, and find out why some investors buy shares in small-cap rather ... Read Answer >>
  5. What are the differences between weak, strong and semi-strong versions of the Efficient ...

    Discover how the efficient market theory is broken down into three versions, the hallmarks of each and the anomalies that ... Read Answer >>
  6. How can I use market capitalization to evaluate a stock?

    Find out how market capitalization affects valuation in fundamental analysis, which valuation ratios use market cap and how ... Read Answer >>
Hot Definitions
  1. MACD Technical Indicator

    Moving Average Convergence Divergence (or MACD) is a trend-following momentum indicator that shows the relationship between ...
  2. Over-The-Counter - OTC

    Over-The-Counter (or OTC) is a security traded in some context other than on a formal exchange such as the NYSE, TSX, AMEX, ...
  3. Quarter - Q1, Q2, Q3, Q4

    A three-month period on a financial calendar that acts as a basis for the reporting of earnings and the paying of dividends.
  4. Weighted Average Cost Of Capital - WACC

    Weighted average cost of capital (WACC) is a calculation of a firm's cost of capital in which each category of capital is ...
  5. Basis Point (BPS)

    A unit that is equal to 1/100th of 1%, and is used to denote the change in a financial instrument. The basis point is commonly ...
  6. Sharing Economy

    An economic model in which individuals are able to borrow or rent assets owned by someone else.
Trading Center