Small Firm Effect

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DEFINITION of '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.

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