As worldwide economic participation broadens and deepens, are large companies (more than small companies) becoming internationally owned and therefore priced? In other words, are large companies subject to a worldwide equity risk premium while small companies remain moored to local risk premiums? In his paper entitled “Financial Integration and the Price of World Covariance Risk: Large vs. Small-cap Stocks” (forthcoming in the Journal of International Money and Finance), Wei Huang investigates whether global pricing is peculiar to large-capitalization stocks. Using three size-based stock portfolios for nine developed countries (Australia, Netherlands, Canada, France, Germany, Italy, Japan, U.K. and U.S.) over the period 1980-2004, he concludes that:
- Nearly all (hardly any) of the foreign companies cross-listed in the U.S. are in the top (bottom) 20% by size in their home markets.
- Large-capitalization stocks show significantly greater comovement across countries than do small-capitalization stocks. The average correlations between the large-cap / mid-cap / small-cap portfolio returns and the world market portfolio return are 67% / 50% / 36%, respectively.
- Global financial integration increased in recent years primarily for large-capitalization stocks. In other words, investors are increasingly pricing large-capitalization stocks, but not small-capitalization stocks, globally.
- The diversification benefits of small-capitalization foreign stocks are therefore greater than those of large-capitalization foreign stocks.
- The behavior of small-capitalization stocks worldwide is more predictable, based on fundamentals, than that of large-capitalization stocks. This greater predictability derives from a (one-way) lead-lag relationship between large-capitalization and small-capitalization stocks and from the stronger calendar effects for the small-capitalization stocks.
In summary, investors in large capitalization stocks are likely accepting a worldwide equity premium. Local (and identifiable) pockets of reward-for-risk involve small capitalization stocks.
