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 Minus Big - SMB

    One of three factors in the Fama and French stock pricing model. ...
  2. High Minus Low - HML

    One of three factors in the Fama and French asset pricing model. ...
  3. Fama And French Three Factor Model

    A factor model that expands on the capital asset pricing model ...
  4. Book-To-Market Ratio

    A ratio used to find the value of a company by comparing the ...
  5. Multi-Factor Model

    A financial model that employs multiple factors in its computations ...
  6. Small-Value Stock

    A description of stock where the underlying company has a small ...
Related Articles
  1. Investing

    Use the Book-to-Market Ratio

    The book-to-market ratio compares the book value of a company to the market value of that same company.
  2. Investing

    An Introduction To Small Cap Stocks

    When it comes to a company's size, bigger isn't always better for investors. Find out more here.
  3. Investing

    Seven Market Anomalies Investors Should Know

    Though they're unpredictable and heavily contested, market anomalies can often work in an investor's favor.
  4. Investing

    Investigating The Stock Premium Puzzle

    The Three-Factor Model tries to demystify the baffling small-cap and value return premiums.
  5. Investing

    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.
  6. Investing

    What's a Small Cap Stock?

    The “cap” in small cap stocks refers to a company’s capitalization as determined by the total market value of its publicly traded shares. Small cap stocks are generally defined as the stock of ...
  7. Financial Advisor

    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
  8. Investing

    Why You Need to Watch Small Caps (IWM)

    Small cap performance impacts broad market tone and direction while revealing important details about market psychology.
  9. Investing

    Six Market Anomalies Investors Should Know

    Certain tradable anomalies persist in the stock market. Here are six that fascinate investors.
  10. Investing

    Small Caps Boast Big Advantages

    Find out why little companies have the greatest potential for growth.
RELATED FAQS
  1. What is the best way to invest in small cap companies?

    Learn about the best ways to invest in small cap companies. Find out when small cap companies yield the highest return and ... Read Answer >>
  2. Are small cap companies a safer investment than large cap companies?

    Learn about the safety of small caps compared to large caps. Find out which key measures they differ on and which to pick ... Read Answer >>
  3. Are small cap companies more risky investments than large cap companies?

    Learn about the risk of small cap companies compared to large cap companies. Compare the volatility of both and learn how ... Read Answer >>
  4. 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 >>
  5. Is there a way to include intangible assets in book-to-market ratio calculations?

    Find out more about the book-to-market ratio and how to calculate a public company's book-to-market ratio including its intangible ... Read Answer >>
  6. How risky are small cap stocks?

    Learn about small-cap stocks and how they are considered riskier than large-cap stocks. Mostly, it is due to a smaller balance ... Read Answer >>
Hot Definitions
  1. Federal Direct Loan Program

    A program that provides low-interest loans to postsecondary students and their parents. The William D. Ford Federal Direct ...
  2. Cash Flow

    The net amount of cash and cash-equivalents moving into and out of a business. Positive cash flow indicates that a company's ...
  3. PLUS Loan

    A low-cost student loan offered to parents of students currently enrolled in post-secondary education. With a PLUS Loan, ...
  4. Graduate Record Examination - GRE

    A standardized exam used to measure one's aptitude for abstract thinking in the areas of analytical writing, mathematics ...
  5. Graduate Management Admission Test - GMAT

    A standardized test intended to measure a test taker's aptitude in mathematics and the English language. The GMAT is most ...
  6. Magna Cum Laude

    An academic level of distinction used by educational institutions to signify an academic degree which was received "with ...
Trading Center