Anatomy of the Small Cap Anomaly March 2011 Update

A large body of research exists on the question of market efficiency and the Capital Asset Pricing Model ("CAPM"). Numerous apparent exceptions to the CAPM have been observed, with the risk adjusted outperformance of small-cap stocks over large-cap stocks being the most commonly cited anomaly. The bulk of the research to date on this topic has found excess returns for stocks below a certain size threshold. The authors conducted two studies, one in November 2009 and another in November 2010 to analyze valuations in a number of developed markets in Europe and Asia across the market cap spectrum. The 2010 study included Canada and the USA in addition to Asian and European markets. While CAPM would lead one to expect a gradual decline in valuations as one looks at smaller and smaller stocks, given that Beta is typically higher for smaller cap stocks, the research in this paper shows that valuations do not correlate with company size in a smooth fashion and that there is a “kink point” below which companies become cheaper faster than the CAPM would predict. The authors posit that the valuation anomaly described by these kink points could help explain the existence of the small-cap performance anomaly, and that the institutional behavior that probably creates these kink points is difficult to change, which could help explain why the small cap anomaly has persisted, despite ample information on the topic.