Rick Welch: Dollars and $ense
Is Market Cap Important?
How important is market capitalization (market cap) in the decision to add a stock to my portfolio? Very important. We advise our clients to consider market cap first, then industry sector and then geography (US or international) when making a security selection decision. Market capitalization, which represents the market’s estimate of the “value” of a company, is calculated by multiplying the price of a stock by the number of shares outstanding. Typically, companies are divided into three market cap classifications: large-cap, mid-cap and small-cap. The cut offs used to distinguish between one cap classification and another are subject to much debate. For the purposes of this article, we will classify large-cap as over $10 billion, mid-cap as between $2 and $10 billion and small-cap as under $2 billion. Do not be surprised if you see additional cap classifications like mega-cap (over $200 billion), micro-cap (below $300 million) and nano-cap (below $50 million). To illustrate this concept consider a company with a stock price of $50 and 100 million shares outstanding – the market cap (or “value”) of this company would be $5 billion and it would be a mid-cap.
When we consider market cap in security selection decisions, we focus primarily on the difference between large-cap and small-cap stocks with the goal of understanding the different sources of risk for each classification. Large-cap companies offer size, strength, industry leadership, diversified business lines, little debt and stability. Many have long established histories of strong earnings and proven track records in the manufacture and/or sale of some of our most popular American brands. As market leaders, large-cap companies often experience a slower growth trajectory and can perform more like value stocks than growth stocks. Small-cap companies offer uncharted territory, increased risk and the realization that price appreciation is based on the expectation of significant future growth, not strong earnings history. Smaller companies that are nimble and less burdened by layers of entrenched management may be better equipped to face the unprecedented technological, social and regulatory change now seen in the global marketplace. These same companies may be able to operate below the radar and dominate niches which are likely to grow in light of these changes. Theirs is a world in which innovations progress faster and the key to success is discovering previously unknown value.
While large and small-cap stocks tend to move together over time (they have a correlation of 0.89), they can deviate significantly from each other during certain phases of a business cycle. Large-cap companies perform better during difficult economic times than do small-caps. Though not immune to recessions, large-cap companies have the experience and resources to weather a recessionary period far better than most small-caps. While small-cap companies often suffer during recession, they regularly outperform the market during the expansion phase of a business cycle. When the domestic economy is strong compared to that of our international trading partners, small-caps will likely outperform. These differing abilities to perform at varying stages of a business or growth cycle suggest that distinguishing investments by market cap can improve diversification within a portfolio of risky assets. Over the past 25 years average price returns for small-caps (+10.47%) have been slightly better than large-caps (+9.93%) with notable periods (consecutive years) of outperformance by both large-cap (1994-98) and then small-cap (1999-2004). Surprisingly, during the same 25-year period large-cap stocks have fallen in just 4 years while small-caps have fallen in 8 years. The largest yearly differential was seen in 1998 when large-caps rose +28.5% and small-caps fell -2.5%.