The Small Firm Effect: Evidence From the Danish Stock Market

Abstract

In 1981, Banz wrote about the size effect, which refers to the observation that smaller firms tend to outperform larger ones in the stock market over the long term. In the years following, there has been a plethora of research replicating the findings. Although the majority of studies concentrate on stocks traded in the United States and other significant economies, limited research has been conducted on stocks traded in Denmark. This thesis aims to address this gap by focusing on stocks traded in Denmark and expanding current research by presenting evidence on the effectiveness of size factor investing in the Danish market.

The empirical analysis of size factor investing, in combination with calendar elements such as the January effect is inspired by the approach of Keim (1983). Further theories of behavioural finance are applied to understand the driving force behind the small firm effect and the January effect.

The thesis finds sorting stocks based on their market capitalization to be a means of identifying stocks on the Danish stock market that over the past 27 years have tended to outperform the market. More specifically, the smallest decile of stocks listed in Denmark outperform all other portfolios formed on size. With a large portion of the returns coming in the month of January, investors are likely engaging in tax-loss selling at the end of the calendar year. In addition, the investor is able to construct an abnormally profitable trading strategy by investing in the bottom 10% and top 30% of the market sorted by market capitalization, while shorting the remainder.