There are some anomalies that shake the assumption of efficient market. One of the most studied is related to the size of the companies. Some authors have demonstrated that smaller companies (that is, the ones with smaller market capitalization) tend to outperform larger firms.
What could be the explanation of this anomaly? In reality it’s very easy. A company’s economic growth is bound to its stocks performance, and the smaller firms grow more easily than the larger ones.
Let’s imagine a big company that needs over $6 billion to achieve a 10% growth rate, while a smaller company needs only $60 million extra sales for obtaining the same growth rate. Therefore, smaller companies are able to grow faster than larger companies, and that is reflected on their stocks.
Many authors have analyzed this anomaly in different markets; but here we focus on the USA to illustrate it. We use S&P500 since 1995 to test if the size anomaly is true. Every day we split up the data into deciles (tenths of the data distribution) according to market capitalization of the stocks comprising the index. So, we create 10 portfolios that invest in each decile.
The two first deciles (composed of the companies with lower market capitalization) get the best performance, which confirms the anomaly in the USA market. The last deciles returns are similar to the S&P500 index itself.
However, smaller companies’ good behaviour is not systematic over the years. Furthermore, smaller companies had a better behavior than larger firms after deep market crisis, like in 2002 and 2008.
The lower the market capitalization, the higher the volatility. Those portfolios comprised of small-caps will be more volatile than others (the volatility of the first decile (small-caps) is approximately 6% higher than that of the tenth decile (large-caps)).
Small-caps outperform large-caps, especially during market rises, but at the expense of increasing the portfolio risk.