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 WHY SMALL CAPS ARE MORE PROFITABLE THAN BIG CAPS
 

   This is a translation of the former paper published by André Gosselin on the OrientationFinance.com web site on September 29 2005 ( Read the original paper in French here).

 

   * Extract written by André Gosselin published in his book "Investir dans les petites entreprises".

   Does the size of the companies explain the differences of return between these two categories of capitalization? It is not known and one does not see exactly why. It is possible that the size of the company is only the demonstration of a deeper phenomenon which is not noticed at the moment. Perhaps the small capitalization securities have some properties, still unknown, which enable the investors to generate better yields than those generated by the larger companies. If such properties exist and if they are crucial, what are they about?

   Some researchers have advanced an extremely interesting explanation, related to the accessibility of the information. To associate the size effect with the information problem is, in my opinion, one of the most interesting insights out there. This assumption is almost valid a priori, because it does not require a whole series of tests to be checked. Indeed everyone agrees to say that the investors have access to less information (financial, administrative, strategic and other) with regard to small companies than to the big ones. They are forced to make increased efforts to get information about the first, otherwise they must assume a greater risk. The fact that small the companies are subjected to less of attention from the analysts and the journalists must be compensated by a higher yield. There is a cost for the effort required in the research of the information when dealing with the smallest and the junior companies of the stock market, and this cost must be compensated by a higher yield.

   If this assumption proves to be well-founded, the stock market would not necessarily be inefficient in what is related to the small capitalization securities. The investors who generate a portfolio return higher than the average by holding such companies deserve the gain they obtain.

   It should also be considered the possibility that the size effect is the demonstration or the consequence of several phenomena which happen simultaneously. For example, the acquisitions of companies usually take place with the purchase of small companies by large ones. In this game, these companies often agree to pay to the shareholders a price which exceeds the one that is traded on the Stock Exchange floor. These acquisitions, though unknown from the majority of the small investors, are real and lead to an increase of the price of the small companies, often well beyond their intrinsic value. A large company which initiates this acquisition is ready to pay this price knowing that it eliminates a competitor and also that this acquisition is less expensive than its internal growth.

   The company size effect on the expected return of their security is a real phenomenon, but it is not know exactly why this phenomenon exists. Is this because of the nature and the quantity of the information which is available about this kind of assets? Is this phenomenon related to the merger and acquisition activities? Are small companies real bargains, business opportunities or underestimated values which can only generate higher profit for the patient investor? The polemic and the mystery remain unsolved.

   André Gosselin

 
 
 
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