The behaviour of small cap vs. large cap stocks in recessions and recoveries: Empirical evidence for the United States and Canada

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Abstract

This paper examines the relative performance of small-caps vs. large caps surrounding periods of peaks and troughs of economic activity, and reexamines the relationship between the small firm anomaly and the business cycle. Small-cap firms outperform large caps over the year subsequent to an economic trough. In the year prior to the business cycle peak, however, small caps tend to lag. US style based large caps perform better over peaks, but there is no dominant category across size and book to market asset classes over troughs. The US small cap premium is related to default risk, although recessions per se do not on average impact on this premium. Default risk and the inflation risk differential between Canada and the US significantly impact on the Canada–US equity premium. Abnormal positive performance observed for US small caps in the recent (post 2001) period as well as for the long horizon is attributable to the small cap growth cohort. Canadian small firm stocks also exhibit significantly positive performance in the post 2001 period.

Introduction

A standard presumption of the efficient markets paradigm in finance is that stock market returns reflect anticipated cash flows of firms in the economy. One of the early challenges to the efficient markets paradigm is the small firm (small cap) anomaly. The essence of this anomaly is that for long term holding periods, small cap stocks outperform large cap stocks (e.g., Banz, 1981, Hawawini and Keim, 1999, Reinganum, 1981, Siegel, 1998). Dimson and Marsh (1999) state that the striking outperformance of small cap companies is “the premier stock market anomaly” that is inconsistent with market efficiency. Bhardwaj and Brooks (1993), Horowitz, Loughran, and Savin (2000) and Schwert (2003) challenge the small-firm anomaly, however. Based on returns that extend to the 1982–2002 period, Schwert concludes (2003, p. 943) the “small-firm anomaly has disappeared since the initial publication of the papers that discovered it.” The issue of small stock outperformance remains a topic of debate across countries. More recently, Switzer and Fan (2007) show that the high returns to small caps may be country dependent, and demonstrate the benefits of adding Canadian small caps for international investors in enhancing their risk-return performance.

Kim and Burnie (2002) suggest that the time-varying nature of the firm size effect may be attributable to the business cycle. They study returns over the period 1976–1995, asserting that differentially higher returns for small cap firms relative are observed during economic expansion phases. Small firm underperformance is shown to occur in their sample over economic contractions. They postulate that this may be due to the relatively lower productivity and high financial leverage during downturns (Chan and Chen, 1991, Kim and Burnie, 2002).2 Switzer and Tang (2009) note that small-cap firms provide a significant nexus for entrepreneurship and innovation and hence might be viewed as less prone to governance problems than large firms; this could in part explain the superior performance of small-cap firms, although leverage, which may be exacerbated during downturns, may hinder their performance.3

This paper provides new evidence on the small cap anomaly for the US and Canada extending the sample to include the most recent recessionary period, which dates the trough of the worst post World War II recession as occurring in June 2009.4 In addition, new evidence is put forth to identify whether the differential returns for small firms vs. large firms are due to the state of the business cycle per se, as asserted by Kim and Burnie (2002) or due to uncertainty factors including default risk, interest rate risk, and inflation risk that may be distinct from business cycle effects for small cap vs. large cap firms. The paper also explores the performance of the Canada vs. US stock premium as a small-country vs. large country variant of the small firm anomaly over the business cycle. Various determinants of the Canada–US equity premium are also examined including the role of changing institutional factors, such as the Canada–US Free Trade Accord (FTA)and the approval of the Multi-Jurisdictional Disclosure System, which enhances the integration of the markets (see e.g., Doukas & Switzer, 2000).

The organization of the remainder of the paper is as follows. Section 2 describes the data. Section 3 revisits the small cap premium in the U.S. and provides some new evidence for a small cap premium for the Canadian market. As is shown therein, it is apparent that the announcement of the death of the small firm anomaly seems premature based on the post 2000 period, in particular for small cap value firms as well as for the experience of Canadian small firms. Section 4 looks at business cycle effects on the U.S. and Canadian small cap premia. In this section explores various risk factors apart from recessions per se as explanatory variables as determinants of the small firm premium. In addition, event study results for differential responses of firms by market capitalization for NBER announcements of recessions and recoveries are presented.

Section 5 looks at the U.S. vs. Canadian stock premium as a large country vs. small country variant of the small cap anomaly.

The paper concludes in Section 6.

Section snippets

Data description

The small cap portfolio returns for the U.S. are based on monthly returns on the Ibbotson/DFA small stock portfolio, which is available from January 1926. The U.S. large cap portfolio from Morningstar/Ibbotson is the S&P 500. The U.S. market portfolio proxy is the CRSP value weighted portfolio of NYSE, AMEX and NASDAQ stocks, which is available since 1926. The Dow Jones Industrial Average (from 1900 on) is also used as a reference for the US market. The US risk free rate is the 1 month T-bill

The small stock premium anomaly revisited

Is the small stock anomaly dead? Table 2 below shows that for the 84-year holding period beginning in 1926, the small cap premium, as captured by the geometric difference between the Ibbotson small cap portfolio return and the S&P 500 has amounted to over 2.03% per year. There is some variability over the decades, it is most noticeable during the 1976–1982 period where it stood at 20.33% on an annualized basis.

Panel B of Table 1 provides estimates of the Jensen (1968) alpha performance

Differential return performance

How do small-caps vs. large caps perform over business cycle peaks and troughs over a long historical perspective? Fig. 1 plots the US small cap vs. large cap indices across all fifteen NBER recessionary episodes since 1926.

The one year market performance from the onset of these recessions is shown in Table 4.

As can be seen in Table 4, over seven of the fifteen recessionary periods since 1926, both large cap and small cap stocks appreciated in value from the onset of the recession to the end of

The US vs. Canadian stock premium as a large country vs. small country variant of the small cap anomaly

Does the Canada–US equity premium behave in a similar manner to the US small-cap premium? One might conjecture that there should be some similarities, given the significantly smaller capitalization of the Canadian market relative to the American market. Indeed as of January 2010, the average listing on the TMX Group has a market capitalization of a conventionally defined small cap firm, at $889 billion; in contrast, the average market capitalization of NYSE companies is over $4 billion.

Conclusion

This paper takes a new look at the small cap premium in Canada and the US. In contrast to various studies pronounce an end to the small cap performance anomaly, the study shows that since 2000, economically and statistically significant abnormal performance is observed for small cap stocks in the US and Canada. The US small cap anomaly in recent years is focused on small cap value stocks. In previous decades where the small-cap anomaly is most pronounced, the anomaly is found for both small cap

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    Van Berkom Endowed Chair of Small-Cap Equities and Associate Director, Institute for Governance of Private and Public Organizations, John Molson School of Business, Concordia University. I would like to thank Christopher Schwarz and participants at the 2010 Midwest Finance Association Meetings as well as Robert Bliss, Martin Bohl, Pierre Siklos, Hamid Beladi (the Editor), and the anonymous referees for their very helpful comments and suggestions. Financial support from the SSHRC and the Autorité des Marches Financiers is gratefully acknowledged.

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