Is the Size Premium Really Driven by Firm Size?

Abstract

By decomposing firm size into horizon-based components, the authors find that the changes in firm size in prior years, instead of its recent level, drive the size premium. Specifically, size five years ago explains 80% of the current firm size but has little predictive power for the size premium. In contrast, the change in size over the prior two to five years explains only 18% of the size but almost completely captures the size premium. Their decomposition indicates that not all small stocks earn a size premium. Only small stocks that had significant losses in market value in the prior two to five years earn a premium. This analysis also offers new insights into the disappearance of the size premium and the return behaviors of new entrants.

TOPICS: Security analysis and valuation, analysis of individual factors/risk premia, quantitative methods, statistical methods, performance measurement

Key Findings

• ▪ The authors decompose firm size into horizon-based components and find the size premium is driven by the size change during the prior two to five years. As such, a better strategy for investors who are interested in the size premium is to trade on the prior two- to five-year size change.

• ▪ Not all small stocks earn a size premium. Only small stocks that had significant losses in market value in the prior two to five years earn a premium.

• ▪ Although the size premium is documented to have disappeared between the early 1980s and early 2000s, the premium related to the prior two- to five-year size change remains strong during this period.