Would you agree if I say that Xiaomi has a larger potential to grow than Apple? Is Xiaomi more probable to double or triple its value than Apple? Is a small-cap stock likely to outperform the large-cap ones? The answer to all the questions is yes. The rationale behind that is what we call the ‘Small Firm Effect’, also known as the ‘Small-Cap Effect’. The small firm effect was famously studied by Nobel laureate Eugene Fama and Kenneth French in their 1992 paper “The Cross-Section of Expected Stock Returns”. It basically suggests that the shares of companies with smaller market capitalization usually offer higher returns to investors in relation to large-cap stocks.
To make things clearer, let’s understand what market capitalization is. Market capitalization is the quantitative value of the company which is calculated by multiplying its share price with the number of shares issued. This value indicates the size of the company in relation to other companies in a similar industry. The market cap of Amazon is 500 times that of eBay. Therefore, Amazon falls under the umbrella of large-cap stocks, whereas eBay is a small-cap stock. Here we come to the end of the stock market lingo lessons.
The most obvious justification of the small firm effect is that smaller companies have a larger scope for expansion and growth. They have the ability to diversify into multiple domains. Consider the following example. Xiaomi recently announced their venture into a new product line of laptops. Their vision is to meet the sudden jump in demand for laptops given the changes in work culture and pedagogy. This will result in a massive increase in market capitalization. On the other hand, if we consider Apple Inc., it is not equally capable of expansion as Xiaomi. Apple has been selling a diverse variety of electronic devices for the last few years. Therefore, we can infer that small firms are likely to give higher returns since they have more growth potential.
This is analogous to the concept of developing and developed nations. Japan, which is a developed nation, witnessed a GDP growth rate of 0.8% in 2018. China, which is a developing nation, exhibited a growth rate of 6.6% in 2018. The gross domestic product of a country is comparable to the market capitalization of the company.
Small-cap companies tend to have a more volatile business environment. This essentially means that the external forces, that are beyond the purview of the company, change rapidly. Therefore, the company responds to these changes expeditiously. This presents a wider scope for correction and improvement to small-cap companies. For example, with the change in policies of the central bank, if the company amends its financial policies or corrects any discrepancies that existed earlier, it could result in the appreciation of its market price.
A mathematical rationale behind this effect is that, since small-cap stocks have a lower share price, even a minor change in price could hold significance in proportion to a large-cap company. A change of 20 rupees would signify an important event in a small-cap stock, but not in a large-cap stock like Reliance Industries.
The small firm effect is often confused with the neglected firm effect. The latter theorizes that publicly traded companies that are not followed closely by analysts tend to outperform the ones that receive attention or are scrutinized. A micro-cap company could possibly triple its market capitalization in the next decade, and suddenly catch eyeballs while it grabbed little to no attention, a few years back. The two effects are not mutually exclusive. A small company that outperformed the larger one might be ignored by the analysts, therefore both the effects apply.
However, small firms are not always loyal. Their ability to survive tougher times like the one prevailing right now is poor. It is mostly the larger firms that yield higher returns in times of recession. As global economies are entering the phase of recession, investors are preferring to invest in large-cap companies, since they have survived multiple recessions in the past and have emerged successfully out of it. A survey by Economic Times suggests that startups are the most affected form of business during this slump.
One of the other reasons why small-cap companies are not a foolproof investment is that their chances of insolvency are higher than that of a larger company. A company such as Reliance has plenty of capital, a strong business model, and an even stronger brand. The probability of default is very insignificant. Therefore such a company or its security would have an investment-grade rating. The smaller companies are likely to default since their credit rating is not as trustworthy. Therefore, their ability to borrow in times of crisis is weak too.
If this article in any way convinces you to blindly invest in small-cap, I’d like to explain how small-cap stocks are not for everyone. Only the investors with a higher risk capacity to stomach the volatility and a long investment horizon must put their money in it. These small corporations need time before they become one of the renowned faces in the industry. And the niche ones take even longer. Patience is of paramount importance when it comes to small firms. But, in all frankness, patience is everything when it comes to the world of bulls and bears.