What it means
Researchers who compare returns across company sizes have often found that small-company stocks beat large-company stocks on average over long spans. Size is usually measured by market capitalisation, which is the share price multiplied by the number of shares in issue.
The gap between the two groups is called the size premium. There are several explanations.
One is that smaller companies are riskier, with less stable earnings and weaker access to finance, so investors demand a higher return as compensation. Another is that small stocks are less researched and less liquid (harder to buy and sell quickly), so they can be mispriced and cost more to trade.
The effect matters for business because it influences how investors estimate the cost of equity, which is the return shareholders require. Some valuation models add a size premium to the discount rate when valuing a small private company, which lowers its estimated value.
Others dispute this, so the adjustment is a matter of judgement and should be explained clearly. For an investor, the effect suggests holding a spread of company sizes instead of only the largest names.
It does not mean every small company will outperform, and individual small shares can fail completely. Most evidence comes from average returns across many stocks, not from any single holding.
An important nuance is that the premium has been inconsistent. Some studies find it has shrunk or disappeared since it became widely known, and it often shows up mainly in short bursts, such as the early part of a recovery.
Higher trading costs for small shares can also eat into the theoretical gain. For a company's own finance team, the practical point is that size affects how investors judge the business.
A small listed company may find its shares are thinly traded and followed by few analysts, so it has to work harder on investor communication to be fairly valued.
In practice
Real-world examples.
Example
A portfolio manager at an endowment fund allocates 20% of her equity holdings to small-company shares to capture the size premium. She accepts that the allocation will swing more than the rest of the fund. She reviews it over a five-year horizon, not quarter by quarter.
Example
A valuation adviser values a family-owned engineering firm for a sale. She adds a size premium of 2 percentage points to the discount rate, which reduces the estimated value of the business. The buyer's accountants question the adjustment, so she documents her reasoning.
Example
A retail investor notices that a small index fund of lower-capitalisation shares has beaten a large-company index over ten years. Before buying, he checks the fund's fees and the volatility of its returns. He decides to invest a modest amount rather than switch his whole portfolio.
Formula
Calculation
Size premium = Average return of small-company stocks - Average return of large-company stocks
Suppose small-company stocks returned an average of 12% a year over a long period, and large-company stocks returned 9%. The size premium = 12% - 9% = 3 percentage points. On an investment of $100,000, a year at 12% earns 100,000 x 0.12 = $12,000, while a year at 9% earns 100,000 x 0.09 = $9,000. The difference is $3,000 a year before costs and taxes, but the small-company portfolio would also have been more volatile.Case study
Seen in the real world.
Fairhaven Asset Partners is an illustrative, fictional investment firm that tested whether to tilt a client portfolio toward smaller companies. Its analyst compared fifteen years of returns on a small-company index and a large-company index.
Small companies had outperformed by about 2 percentage points a year on average, but there were long stretches in which they lagged, including a four-year period when large companies led strongly. The analyst also noted that trading costs on the small-company holdings were noticeably higher.
The firm decided to add a modest small-company allocation with a long holding period and clear expectations for the client. The illustrative lesson is that the small firm effect is an average tendency, not a promise that arrives on schedule. The client agreed to review the allocation after five years and not to judge it on any single year's result.
Watch out
Common mistakes.
- Believing that every small company will outperform, when the effect describes the average of many stocks and individual shares can fall sharply.
- Ignoring risk and trading costs, which can reduce or remove the extra return after expenses.
- Assuming the effect is permanent, when its size has varied across time periods and may have shrunk.
Questions
People also ask.
Why might small firms earn higher returns?
Possible reasons include higher risk, lower liquidity and less analyst coverage, which together can lead investors to demand a higher return.
Does the effect apply to private businesses?
Valuers sometimes add a size premium to private company discount rates, though the practice is debated.
How is company size measured?
Usually by market capitalisation, which is the share price multiplied by the number of shares in issue.
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