What is the Small Firm Effect

The small firm effect is a theory that holds that smaller firms, or those companies with a small market capitalization, outperform larger companies. A small capitalization stock is considered to be a stock with less than $2 billion in market capitalization. The small firm effect 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. Of course, verification of this phenomenon is subject to some time period bias. The time period examined when looking for instances in which small cap stocks outperform large caps largely influences whether or not the researcher will find any instance of the small firm effect. At times, the small firm effect is used as rationale for the higher fees that are often charged by fund companies for small cap funds.

BREAKING DOWN Small Firm Effect

The small firm effect is a 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.