Why do smaller companies earn higher returns than larger firms? An empirical investigation of the Size Effect using survey data

Banz (1981) was the first scholar to observe that smaller quoted firms earn higher returns than larger companies. This observation has become known as the “size effect”. The objective of this paper is to explore whether the observed higher returns are indeed a response to the higher risks faced by smaller firms, as hypothesized by Berk (1995). It is hypothesized that the size effect is a result of smaller businesses needing to earn higher returns in order to compensate for the greater risks faced by such firms. However, whilst the size effect has been widely researched, there has been little empirical work to explore whether management behaviour in smaller firms provides evidence that higher returns are sought in order to compensate for the greater risks faced by owner / managers and investors. First, the authors provide evidence that the size effect is observable in unquoted SMEs as well as quoted firms, using a new dataset from the USA. Second, the authors collect survey data on investment decision making in both large and smaller UK firms. The results shows that smaller firms use less sophisticated approaches to investment decision making, in some cases simply investing on the basis of perceived business needs. However, the predominant heuristic used to aid investment decision making is the length of time needed to recover the cost of fixed capital invested (i.e. payback). Smaller firms typically use shorter time periods than larger businesses, thereby implying that they acknowledge that higher returns are needed. Whilst the size effect has been observed over the past three decades the explanation that it is caused by the higher levels of risk faced by smaller businesses, whilst consistent with Markowitz’s (1952, 1959) portfolio theory and in contradiction of the Sharp-Lintner (1964/1965) capital asset pricing model, has remained un-tested. This paper contributes support for the theory that higher returns are required to compensate for risk, based upon the observed management practices of smaller quoted and unquoted firms. These observations provide support for the “size effect hypothesis” based upon the investment decision making criteria used by owner managers and financial directors in relatively smaller businesses.