Structural and Return Characteristics of Small and Large Firms

TLDR: In this article, the authors examine differences in structural characteristics that lead firms of different sizes to react differently to the same economic news and find that a small firm portfolio contains a large proportion of marginal firms-firms with low production efficiency and high financial leverage.

Abstract: We examine differences in structural characteristics that lead firms of different sizes to react differently to the same economic news We find that a small firm portfolio contains a large proportion of marginal firms-firms with low production efficiency and high financial leverage We construct two size-matched return indices designed to mimic the return behavior of marginal firms and find that these return indices are important in explaining the time-series return difference between small and large firms Furthermore, risk exposures to these indices are as powerful as log(size) in explaining average returns of size-ranked portfolios WHY DO SMALL CAPITALIZATION stocks earn higher mean returns than large capitalization stocks? One view is that small and large stocks have different sensitivities to the risk factors important for pricing assets (see Chan, Chen, and Hsieh (1985) and Huberman, Kandel, and Karolyi (1987))1 This view emphasizes that the risk differences between small and large stocks arise from the differences in their time series responses to changes in the underlying risk factors Chan, Chen, and Hsieh (1985) find that small firms are more exposed to production risk and changes in the risk premium Huberman, Kandel, and Karolyi (1987) find that returns of firms within the same size range tend to respond to risk factors in similar ways, and their returns tend to move together Although these studies have shown that there are risk differences between small and large firms, they do not suggest why Smallness by itself does not necessarily imply higher risk, and differences in market capitalizations do not explain why small and large firms have different responses to economic news This study suggests that the small firms examined in the empirical litera