Investor Preference for Large Firms: New Evidence on Economies of Size

Abstract

IN the last several decades, industrial organization literature has been replete with studies demonstrating a systematic relationship between accounting rates of return and firm size in the direction of greater (and more stable) accounting profits for larger firms.' These studies have been subject to criticism for an alarming number of statistical and conceptual problems, the most important of which alleges a serious bias in accounting profit measures as proxies for economic profit.2 The criticisms have resulted in a stalemate in the interpretation of empirical evidence on firm size and performance. Nevertheless, there is continued interest in the area, ostensibly resulting from policy concerns with large firm advantages in both product and capital markets. This paper provides new evidence concerning the industrial organization literature controversy of the connection between firm size and performance. Stock market data are used to examine the relationship between capital market returns, risk, and firm size. The findings suggest that even if there were no advantages of large size in the product market (equal rates of operating profit), large firms would still have a substantial capital-raising advantage over small firms. This advantage is unrelated to the widely recognized floatation cost economies. Even after controlling for nondiversifiable risk using the Capital Asset Pricing Model (CAPM), investors still demonstrate a statistically significant and economically important preference for the securities of larger firms. Investors apparently place a premium on large firms which is not attributable to large firms' observed lower risk as captured by the widely used measure of nondiversifiable risk (beta risk). This finding, a fresh contribution to the