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Can Small Company Bias Beat the Efficient Market Hypothesis

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Nika Simonson

Many are fascinated with the possibilities of well-known anomalies having the potential to outperform the market and challenge the efficient market hypothesis (EMH). According to the EMH, stocks always trade at their fair value on stock exchanges, making it impossible for investors to either purchase undervalued stocks or sell stocks for inflated prices.

There are three forms of the EMH including the weak form, semi-strong form, and strong form efficiency. The weak form claims that all past prices of a stock are reflected in today’s stock, therefore, technical analysis of past stock prices cannot be used to beat the market. Semi-strong form goes one further in implying that all public information is calculated into a stock’s current share price, therefore fundamental analysis, along with technical analysis, cannot be used to achieve abnormal returns. In the strong-form efficiency it states that share prices reflect all past stock prices, public information, and even private information, thus no one can earn excess returns.

Small company bias is the theory that stocks of small firms, or firms that have a small market capitalization, have outperformed and earned abnormal returns in comparison to large market capitalization firms. This theory challenges the strong form of the efficient market hypothesis. Small company bias has been a reoccurring theme over history when trends should not be predictable. The theory of the neglected-firm effect has shed some insight into the possibilities of why this occurring.

According to the neglected-firm effect, small firms tend to be overlooked by large-institutional traders. Information about smaller firms is less available and the lack of this information makes these firms more risky. Brand name firms are also subject to considerable monitoring from institutional investors, leaving small companies on a looser leash.

According to research done by Amihud and Mendelson, the effect of liquidity on stock returns could be related to both the small firm and neglected-firm effects (McGraw 242). Small and less-analyzed stocks are typically less liquid and therefore investors will demand a rate-of-return premium that will entail higher trading costs. Also, spreads for less-liquid stocks can be more than 5% of their stock value. Thus these stocks show a strong tendency to exhibit abnormally high risk-adjusted rates of return.

The Russell Global Indexes represent the investable global equity market and its segments comprehensively. The index includes more than 10,000 securities in 47 countries and covers 98% of the investable global market. They conducted research on small capitalization firms compared to large capitalization firms over the year of 2013 against the new year of 2014 up until January 17. The index has found that small cap firms tend to outperform large cap firms. The graph included below displays the results (Hersch).

Index 2014 YTD 2013
Russell Developed Europe Large Cap Index 2.1% 19.9%
Russell Developed Europe Small Cap Index 4.2% 31.2%
Russell 1000 Index 1.3% 27.4%
Russell 2000 Index 2.0% 32.8%
Russell Global Large Cap Index 1.2% 18.9%
Russell Global Small Cap Index 2.5% 19.9%
Russell Emerging Markets Large Cap Index -1.5% -4.9%
Russell Emerging Markets Small Cap Index 1.4% 1.1%

As noted in the graph above, the European small market capitalization index doubled the performance of the European large capitalization index 4.2% to 2.1%. The Russell 2000 index, which is the U.S. small cap index also outperformed the U.S. large cap index, the Russell 1000. Globally, small capitalization firms doubled the performance of large capitalization firms over the same time period. The same was true for firms in emerging markets.

The small firm effect, however, cannot be completely explained by the efficient market hypothesis or other theories, including the liquidity effect, and thus still remains an anomaly to the EMH. The graph above may also have skewed results due to the January effect. The January effect is another anomaly in which there is a general increase in stock prices during the month of January. Despite all the facts, the real question is if one could profit off of the small company bias theory.

In conclusion, in order to profit off of small company bias, an investor would have to rely on the fact that history will repeat itself, which may not always be the case. Trading costs and taxes also deplete the returns one receives from the phenomenon. In addition, small company bias is a well-known theory which by definition of the efficient market hypothesis should make it difficult for everyone to profit off of it if everyone knows about it. Therefore, it would not be wise for an investor to try and beat the efficient market hypothesis, along with the market, by using the small firm effect.

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http://highered.mcgraw-hill.com/sites/dl/free/007338240x/773409/Sample_Chapter_8_New.pdf

Hersch, Warren S. “Small Cap Stocks Outperforming Large Cap in 2014.” Insurance News & Sales Ideas    for Life & Health Insurance Professionals. N.p., 24 Jan. 2014. Web. 25 Feb. 2014.

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