What is Wrong with Small Stocks?

Abstract

This paper uncovers several new empirical regularities in the historical returns of small stocks. First, within the sample of firms that have low market capitalizations, stocks with low past profitability (laggers) bring returns significantly higher than those of stocks with high past profitability (leaders). Second, the well-documented size premium (i.e., the risk-adjusted returns to small stocks) is generated largely by small laggers. Moreover, both patterns are particularly pronounced at earnings-announcement dates, suggesting that unexpected earnings growth can explain a portion of the abnormal returns to small stocks. There is little institutional ownership of small stocks, pointing to individual investors as the culprits of suboptimal trading. Institutional avoidance of small stocks therefore can explain the persistence of the mispricing. The analysis indicates that the documented effects are driven consistently by those small stocks that have had a prior decrease in institutional ownership ratio.