Please Note: Blog posts are not selected, edited or screened by Seeking Alpha editors.

A Note About Smaller Risk Of Small Public Companies (15 Feb. 2012)

It is well documented that small public companies with capitalization well below average or median (small-cap stocks) and so-called value stocks with a high book-to-market ratio outperform the broad market. In order to describe stock returns within framework of traditional finance Fama and French published famous three-factor model in 1992. In this model they explained small-cap and value effects with two factors (one for size and one for value) additional to classical beta used in Capital Asset Pricing Model for which Sharpe, Markowitz and Merton Miller received the Nobel Prize in Economics. Being a student of a Nobel Price winner in Physics (sorry cannot disclose the name) I'd like to point a new (as far as I - an amateur investor know) aspect.

I think that the bottom line of Fama-French paper important for this note is: SMALL CAP STOCKS OUTPERFORM MARKET BECAUSE THEY ARE MORE RISKY.

Although the term risk is not well defined in finance at least volatility (which is often used as the risk proxy) of small-cap stocks is indeed higher than volatility of large cap stocks. Intuitively it should be so because less amount of money is needed to shift small-cap stock price to compare with stock of big company.

But in my opinion there are two interrelated risk factors that are SMALLER for small public companies than for large one, because of the following factor.

An annual financial report of a small company with often 1 line of business is usually simpler (and shorter) that the same report of a big company with several branches.

Hence I can make 2 statements:

Risk 1: Auditors make less mistakes approving annual financial report of a small company to compare with big company report. Therefore numbers are more trustable in a small company report than in a big company report.

Risk 2: It is easy to comprehend an annual financial report of a small company than an annual financial report of a big company, so an investor (and/or an analyst) makes more explicable action with stock of small company to compare with stock of big company.

Well, I don't think that my statements are bulletproof. My goal is rather to show that the term risk is not well defined in finance.

Disclosure: I invest in some small-cap and large cap companies and receive their annual reports but not always read these reports. Most of my investment are in dividend stocks of small- middle- and large-cap companies and risk of this investment has almost nothing common with price volatility and Fama-French model.