The reasons explaining this development have been alluded to previously. The asset base of employer- sponsored pension funds has grown dramatically since the 1980s due chiefly to increased asset allocations to public equity and more capital market participation among large public sector plans.
All mainstream exchanges function through an auction process for buying and selling listed securities that is negotiated and shaped by investment brokers, dealers, and specialty agents (e.g., registered traders) on behalf of investors. Auctions are, in turn, based on a familiar universe of common and preferred stocks. Types of stocks are determined by prices that mirror the underlying characteristics and financial performance of enterprises, histories of dividend payments and cyclical trends. The highest profile stock type is the blue chip, identified with the shares of the country's largest and most established corporations, such as those that constitute the TSE 35 Index.
Blue chip stocks also indicate market capitalization (i.e., overall dollar worth, determined by multiplying the stock price by the number of shares outstanding) that is, of course, quite substantial. In general, large- capitalization equity stocks (or large-caps) exist above a threshold of $1-2 billion - depending, of course, on what definition, or market index, one uses to distinguish them from small-capitalization equity stocks (or small- caps).
Again, depending on the point of reference, small-cap stocks can be said to exist below the $1 billion level, though as suggested above, some market analysts and practitioners believe stocks do not surpass low- capitalization until they have hit the $2-2.5 billion mark. Others refer to further size gradations, such as micro/small-caps which may reach uppermost limits of $50-500 million and mid-caps which may exceed these limits.
Assorted formal indices for benchmarking small-caps, such as the Russell 2000 in the United States, and at home, those established by CIBC Wood Gundy, James Capel Canada, Midland Walwyn and Nesbitt Burns, are among those that describe this market segment for trading purposes. Perhaps the most commonly quoted is the Nesbitt Burns version which consists of stock issues with a market float of less than 0.1 percent of the TSE 300 Index's total value - or a range of roughly $65 million to over $700 million in early 1998. Stocks are drawn from 400 enterprises and five different sector categories - consumer products, industrial goods, natural resources, energy and interest-sensitive industries.
Total capitalization of the Nesbitt Burns Index was $94 billion in 1997, as compared to the $651 billion TSE 300 (see Figure 11). Small-cap stocks can also be found in some broader indices (e.g., TSE 200).
Considering the size effect of public equity investing is a fairly recent exercise. Over the past two decades, voluminous research literature has been produced, tending to confirm small-cap out-performance of large- caps, at least for stretches of five to seven years and in the longer-term. This conclusion uprooted notions of securities exchanges of near perfect efficiency and transparency, based on extensive publicly disclosed information about listings. Rather, small-cap stock behaviour appears to indicate a relative market inefficiency that, if properly exploited, can reap superior financial returns. The downside is, however, greater illiquidity, volatility and risk, compared to their opposites.Endnote 82
Much of this phenomenon can be explained by the underlying business characteristics of small-caps, such as below average size, youth and, perhaps most meaningful of all, a propensity for exponential growth. The latter quality suggests why many small-cap stocks are also growth stocks, demonstrating significant price movements. Indeed, small-cap and growth stocks often align in emerging firms that are knowledge-based and technology-intensive and from other sectors with less profile in the industrial mix of large-caps. They may also be value stocks, or those priced to suggest neglect by investors that is mistaken due to strong underlying business and financial fundamentals.
Because there is less reliable information in circulation about low-price, small-cap stock issues, it must be collected directly by investors or their intermediaries. Richer data implies a reasonably accurate estimate of future earnings, since most of these stocks cannot be evaluated according to records of historic return patterns.