In this chapter, Dreman takes apart some common stock market beliefs. He spends the most time critiquing the "small-cap effect". It's commonly believed in the investment world that small stocks outperform large ones. Some widely cited papers have even claimed the low P/E effect (where stocks with lower P/E's tend to outperform stocks with higher P/E's) does not exist when one takes into consideration the small-cap effect.
Dreman takes apart some of these claims by examining the data and pointing out the pitfalls of several such studies. The most important point to note about some of these studies is the liquidity issue of small-caps. Dreman demonstrates that because of large bid-ask spreads and commission costs of purchasing the small-caps cited in the studies (which go back to the 1930s, when bid-ask spreads for small caps were on the order of 40% of the stock price), the returns shown by the studies are theoretical and could never have been achieved in practice. Furthermore, small-caps don't trade enough for investors to have been able to scoop up enough shares, and purchases in these small issues would have changed the prices of the stocks considerably, none of which is captured in the data.
Dreman goes on to cite a subsequent study he performed which shows the P/E effect to be very much alive, and across all sizes of stocks. After dividing the universe of stocks into quintiles by size, Dreman shows that it's the P/E effect that drives the returns of small-caps as much as it does for large caps. Buying small stocks with high (low) P/E's provides similar returns to buying large stocks with high (low) P/E's.
Dreman also confirms these results using P/B and P/CF measures, suggesting that small-caps as a group perform only marginally better than large-caps, but that they do so because of the strong returns of the beaten down stocks (as measured by their earnings, book values, or cash flows).
Finally, Dreman offers some caveats for investors interested in small-caps. One of the most important items to note is that transaction costs are not simply equivalent to commission costs. Large bid-ask spreads represent very real transaction costs that are not captured by commissions. Investors must recognize this when making purchase decisions, or they may see their supposedly higher returns eroded, much to their surprise.