Cost of Capital: Applications and Examples, + Website, 5th Edition

CHAPTER 15

Criticisms of the Size Effect¹

Roger J. Grabowski and James Harrington

Introduction

Is the Size Effect the Result of Incorrectly Measuring Betas?

Barra's Fundamental Betas

Composition of the Smallest SBBI Valuation Yearbook Decile

Composition of the Smallest Risk Premium Report Portfolio

Data Issues

Risks of Small Companies

The Size Effect with Boom Years Omitted

Is the Size Effect Limited to Only the Smallest Companies?

Has the Size Effect Disappeared in More Recent Periods?

Should the Cost of Equity Capital Use a Changing Size Premium?

Relationship of Size and Measures of Risk

Relationship of Size and Liquidity

Summary

Appendix 15A: Other Data Issues Regarding the Size Effect

INTRODUCTION

In Chapter 14, we discussed two sets of studies that document and quantify the size effect: the Morningstar studies and the Duff & Phelps studies.

The size effect is not without controversy, though, and various commentators question its validity. In fact, some commentators contend that the historical data are so flawed that practitioners can dismiss all research results that support the size effect. For example, is it simply the result of not measuring beta correctly? Are there simply market anomalies that cause the size effect to appear? Is size just a proxy for one or more factors correlated with size, so you should directly use those factors rather than size to measure risk? Is the size effect hidden because of unexpected events?

IS THE SIZE EFFECT THE RESULT OF INCORRECTLY MEASURING ...