Introduction
Efficient market hypothesis
The theory of efficient market hypothesis holds that all relevant information about the ‘true’ value of an asset that can be found in the market is reflected in its market price. This implies that there is no room for arbitrage in the market. Past research studies revealed that there is efficiency in the stock markets, especially in reflecting information about the stock market and securities. The proponents of this theory argued that if there was information, it was disseminated and reflected in the prices of stock at a faster rate. An arbitrage opportunity exists if investors are aware that some stocks are either overvalued or undervalued. This encourages investors to trade until the present value of the future cash flows equals the price of the stock. This implies that the search for stocks that are not priced correctly and the consequent trading restores the intrinsic value of these stocks. This process leads to the achievement of efficient markets. An efficient market is associated with the concept of ‘random walk’. This is based on the fact that the impact of new information on the stock market is expected to be random. It can either have a positive or negative effect. Thus, an investor cannot earn high returns in an efficient market (Brealey, Myers & Allen, 2005).
Small firm effect
The earlier research studies carried out revealed that there was strong evidence that supports the efficient market hypothesis. However, in recent years, evidence shows that there are a number of anomalies that are associated with this hypothesis. An example is the small firm effect. Recent studies that have been carried out reveal that investing in entities that have a small market capitalization will generate a high value of the risk-adjusted return. This can be attributed to the fact that such firms have a greater growth potential than larger firms. This effect is experienced over a long period of time.
Relationship between the small firm effect and efficient market hypothesis
The small firm effect is a theory that contradicts the efficient market hypothesis. Based on the discussion above, the small firm effect can be attributed to either the amount of required return for some unspecified risk, inefficiency in the market, or a coincidence. Thus, the paper will discuss the small firm effect and the reliability of the three possible causes of this anomaly mentioned above.
Discussion
Efficient market hypothesis
A number of studies have been carried out on the concept of the efficient market hypothesis. Burton Malkiel (2003) pointed out that both technical analysis and fundamental analysis cannot give an investor an upper hand in earning higher returns than other securities with the same amount of risk (Malkiel, 2003). Technical analysis focuses on evaluating the past trend of the performance of a stock in order to predict the future trend. On the other hand, fundamental analysis focuses on evaluating the earnings and the value of a company in order to find out undervalued stock. The author is of the opinion that the prices of stock wholly reveal all the information that is known. Thus, there will be no difference between the amount of return earned by investors who buy assets at the tabulated prices and those who hire experts to analyse these assets first before buying them. The author further pointed out that in the recent years, there has been contradiction to this hypothesis. Thus, the future performance of shares can be predicted and investors are able to make undue gains predicting the future trends of a stock. The ineffectiveness of this hypothesis can be explained by a number of anomalies such as the small firm effect. Despite these contradictions, the author is still of the opinion that the efficient market hypothesis holds.
Eugene Fama (1991) indicated that the concept of market efficiency changes gradually over time (Fama, 1991). The author has indicated that “the efficiency of market can be improved by lowering cost of obtaining information, transaction costs, and trading costs” (Jones & Netter, 2008). Thus, the advancement of technology improves market efficiency. The author pointed out that informational efficiency is vital because investors are interested in coming up with strategies that can earn them higher returns and investments will be channeled to high valued assets if the efficient market hypothesis holds. Thus, it helps in allocating resources.
In a separate research, Fama (1991) came up with the three forms of market efficiency (Fama, 1991). The first one is the weak-form efficiency market. Under the weak form, “the prices of securities reveal all information of historical prices” (Fama, 1991). Thus, technical analysis cannot provide additional returns. This implies that the past trends and any other market indicators cannot be used to predict future performance of a stock. However, Park and Irwin (2007) reviewed the empirical evidence on the profitability of technical analysis (Park, & Irwin, 2007). They categorized their studies into two. “The results of their early studies indicated that technical analysis was profitable in some markets such as future and foreign exchange, but not in the stock market” (Park, & Irwin, 2007). Further, in their modern studies, they established that technical analysis was profitable in speculative markets. Grossman and Stiglitz (1980) had a different opinion. The authors indicated that the informational efficiency will deter investors from carrying out technical analysis (Grossman & Stiglitz, 1980). This will not guarantee that the information relayed in the market is correct. This makes the extreme level of market efficiency to be inconsistent on the inside. These results show that some markets are weakly inefficient.
The second form was the semi strong efficiency. This form of efficiency states that fundamental analysis is not profitable because the prices of securities reveal all information that is available in the public domain. The difference between the weak and the semi strong form is that all public market data and all fundamental analysis for companies can be obtained at no cost. Even though empirical findings supported the semi strong form of market efficiency, especially in the 1970s, there were contradictions that arose during the same decade. The most common were the ‘small firm’ and the ‘January effect’ (Schwert, 1983). However, “these anomalies have been attributed to the wrong specifications of the models used for study and market frictions” (Jones & Netter, 2008). For instance, the concept of small firm and January effect were interpreted as compensation or premiums for undisclosed risks. The stock of smaller firms tends to be volatile when the year is changing. Thus, the high returns observed in the case of small firms compensate for the risky nature of their stocks. Fama (1998) further pointed out that the small firm and January effects can be regarded as random manifestations that were expected to disappear if methodologies and time period were changed (Fama, 1998). The findings of Fama were supported by Robert Shiller (1981), DeBondt, Werner, and Richard Thaler (1985), Lawrence Summers (1986), and Narasimhan Jegadeesh and Sheridan Titman (1993) (DeBondt, Werner & Thaler, 1985; Jegadeesh, & Titman, 1993; Shiller, 2003; Shleifer & Vishny, 1997; Summers, 1986). However, their research studies focused on long term returns. They established that the stock market index was more volatile than dividends. They also established that the concept of mean reversion was valid. This implies that if high performance is reported within a given period, then it will revert in the future. This will result in a mean negative return. A similar trend was observed in the case of stock that earned high in three to twelve month period. The trend of such stock will revert in the next three to twelve month period. Therefore, there is adequate evidence that supports mispricing of stock (Jones & Netter, 2008). The evidence from research carried out by Fama indicates that the small firm effect is a short term phenomena and should be treated as a mere coincidence. However, the new findings discussed above indicate that it is a long term phenomena that tend to be cyclic. Thus, it can be concluded that the small firm effect is permanent (Barber & Lyon, 1997).
The third one is the strong form efficiency. This form of efficiency indicates that any accessible data and facts are captured in the market prices of assets. This information can be either private or public. Thus, confidential information does not offer higher returns. “This form is the highest level of market efficiency and it requires that the private and privileged information of entities to be reflected in the stock prices” (Jones & Netter, 2008). However, this may not be practical making this form of market efficiency a simple limiting case.
Capital asset pricing model
The concept of asset pricing model (CAPM) was introduced by William Sharpe (1964) and John Lintner (1965) (Sharpe, 1964; Lintner, 1965). The model is commonly used in pricing of assets. The model takes the form:
Rit−Rft = ai + bi ( Rmt−Rft) + eit
Where: Rit is the return on asset, Rft is the risk free rate of return, Rmt is the return on the market portfolio, ai measures the difference between the return of the asset and return predicted by the CAPM, and bi measures the market risk of the asset. Despite being widely used in the world today, the CAPM has a number of criticisms. A research that was carried out by Fama and French (2004) revealed that CAPM is not suitable for use (Fama, & French, 2004). The result of their study revealed that funds that were invested in small or low value stock and in low beta generated positive and higher returns than those generated through CAPM. The findings of these two authors are connected to the efficient market hypothesis because CAPM is built on the assumption of this hypothesis. The implications of their findings indicate that using CAPM to value stock results in investing in assets that have a higher level of risk and the actual ideal level. The authors indicated that the model weakened by the fact that there was no relationship between return and beta (as a measure of systematic risk). This was observed when evaluating the relationship between size and returns. Thus, they recommended that size should be used as a proxy of risk instead of beta (Donald, 1986). These findings also weakened the validity of the small firm effect. The discussion above shows that CAPM is not effective. This calls for the use of other models such as multifactor model.
Small firm effect
A research study that was conducted by Banz (1981) and Reinganum (1981) indicated that firms that had a low capitalization of the New York stock exchange market generated higher returns than what had been predicted using the CAPM model (Banz, 1981; Reinganum, 1981). Banz (1981) established a negative relationship exists between the market value of the stock and the return on such stock (Banz, 1981). The research implies that small firms have the potential of earning higher returns than large firms over a long period of time. There are several research studies that have carried out and they seemed to support these findings. Based on the discussion in the previous section, the existence of a small firm effect can be attributed to a number of factors. The first factor is risk. Research carried out by Banz (1981) revealed that small firms offered higher returns than their level of risk (Banz, 1981). Later studies that were carried out revealed that the size of the firm had an impact on the returns of a stock.
The second hypothesis that supports the existence of small firm effect is informational efficiency. In the market, there is less information about the smaller firms as compared to larger firms. Thus, the high return compensates for the process of gathering information of such entities (Williams, 2005). Also, the absence of adequate information creates room for arbitrage hence the high returns. The final factor is the relationship between the small size firm effect and economic cycles. Entities that have small capitalization tend to have low efficiency and a relatively high leverage. This makes them quite vulnerable to the swings in the economy, which implies that much higher returns should be earned when the economy is experiencing boom because they will be offset by losses earned during recessions. Therefore, these arguments tend to support the existence of the small firm effect. However, the critics argue that there are several large firms that generate high returns (Fama, Fisher, Jensen & Roll, 1969).
Comparison of the small firm effect and efficient market hypothesis
The relationship between the small firm effect and the efficient market hypothesis is captured in CAPM. As indicated above, the asset pricing model is built on the assumption of this hypothesis. “In the capital asset pricing model, beta is used to measure risk of an asset, that is, the extent to which the return of the asset will vary when the return of the entire market varies” (Malkiel, 2003). If beta is used to measure risk, then the size effect can arise from market inefficiency. This can be attributed to the fact that smaller entities offered higher returns than their level of risk, implying that beta is not efficient in measuring risk. This makes CAPM inefficient.
Conclusion
In summary, the discussion shows that the small firm effect is a contradiction of the second form efficient market hypothesis. Further, the small firm effect is permanent in nature. Also, the small firm effect has a negative association with the efficient market hypothesis and this weakens CAPM. Thus, due to the numerous anomalies and inefficiencies, the best strategy for investing is to buy and hold.
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