The size effect assumes a negative relationship between average stock returns and firm size. In other words, it states that low capitalization stocks outperform stocks with large capitalization. Academics propose several possible explanations why this happens, including greater flexibility of small firms, more space for them to grow and higher inside innovation.
Although generally accepted, the size effect keeps being challenged. Researchers have been asking how important the firm size characteristic actually is, and whether it is possible to replace the traditional size factor of Fama and French asset pricing model (1993) with more accurate factor. Recently, one potential challenger has emerged – so-called takeover factor, employed by Easterwood et al. (2022). In their study, they work on the assumption that small firms are often targets of takeovers, which gives us a different perspective on merger and acquisition news in regards to size effect. Their results show that M&A component of average returns explains the size premium entirely; returns on takeover factor are in correlation with SMB returns, and finally, while takeover factor models are able to estimate the size factor, it does not work the other way around.
To sum it all up, according to research of Easterwood et al. (2022), takeover factor should replace the conventional size factor in benchmark asset pricing models as merger announcement component of returns drives the entire measured size premium.
Authors: Sara Easterwood, Jeffry Netter, Bradley Paye, Michael Stegemoller
Title: Taking Over the Size Effect: Asset Pricing Implications of Merger Activity
We show that merger announcement returns account for virtually all of the measured size premium. An empirical proxy for ex ante takeover exposure positively and robustly relates to cross-sectional expected returns. The relation between size and expected returns becomes positive or insignificant, rather than negative, conditional on this takeover characteristic. Asset pricing models that include a factor based on the takeover characteristic outperform otherwise similar models that include the conventional size factor. We conclude that the takeover factor should replace the conventional size factor in benchmark asset pricing models.
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