What Investors Should Know About Market Capitalization

While large-cap stocks remain the most popular among investors, traders and fund managers, it’s still important to focus on having a diversified portfolio to withstand both up and down markets. Using market capitalization to understand a company’s size is an important characteristic for investors to know in determining their investment strategy and risks.

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What Is Market Cap?

The market capitalization of a company is a term that most investors have heard of but might not be familiar with, says Mike Loewengart, chief investment officer at E-Trade Financial, a New York-based brokerage company.

Market cap is defined as the total number of outstanding shares of a company multiplied by the current market price of one share. For instance, a company with a total number of 50 million shares, with $100 per share, is worth $5 billion in its market cap. This is an important factor because categorizing stocks by their market cap can be useful when gauging a company’s size, riskiness and international exposure, Loewengart says.

“A solid understanding of a company’s market cap and what it means can help guide your investment decisions,” Loewengart says.

Small Caps Tend to Be New Companies

Newer or relatively young companies are known as small caps and tend to be domestic companies that focus on a specific industry and have a market cap between $300 million to $2 billion.

“Although their track records won’t be as lengthy as those of the mid to large caps, they do present the possibility of greater capital appreciation, but at the cost of greater risk,” he says.

Small caps are often overlooked by investors because the returns can be more volatile. For the past 20 years, small-cap indices outperformed large-cap indices over the long run, says Derek Horstmeyer, an assistant professor of finance at George Mason University.

Some periods are outliers. Over the past five years, the S&P 500, a large-cap benchmark index, has outperformed the Russell 2000 by 10%.

If credit conditions are tightening, investors should avoid selling their small-cap stocks or mutual funds and moving into large caps, Horstmeyer says.

“Usually when economic data worsens small caps take a bigger hit,” he says. “When an investor sells their small caps after this news, the stock price has already fallen. In effect, the investor is selling their small caps at a low point if following this strategy.”

Stocks with a small market cap are more volatile and less liquid and may not be a good fit for all investors, depending on the amount of risk they want to take, says Jodie Gunzberg, chief investment strategist at Graystone Consulting, a Morgan Stanley business in New York.

“However, if some small caps can be tolerated, they can offer some diversification benefits and may do well with U.S. growth and a rising dollar since most of their business is domestic,” she says on this category for growth potential.

Since these stocks are typically younger companies that are growing more aggressively, they often offer “greater potential gains in share price and a higher return for investors,” Michelson says.

“For example, a small cap with a $250 million market cap is more likely to double in value than a large-cap stock at $250 billion,” he says.

Stocks also have different valuations and dividend yields. On average, small caps over the short and long term carry the highest forward 12-month price to equity ratios, followed by mid caps and then large caps, Gunzberg says.

Mid Caps Add Diversification

Mid-cap stocks add greater diversification to a portfolio since these companies are well-established but can produce higher rates of return than larger, established companies. A few examples of companies in this category include Whirpool (ticker: WHR) and Aqua America (WTR).

These stocks are often impacted more by economic factors and interest rate changes and could experience some volatility and are often overlooked by investors. Mid-cap stocks range from $2 billion to $10 billion.

“Generally, mid caps have been good performers over longer periods, so diversification with mid caps may benefit a portfolio,” says Stuart Michelson, a finance professor at Stetson University.

Mid-cap value companies could be strong acquisition targets with big potential gains. While large-cap value stocks often pay large dividends, small-cap value stocks may give the most exposure to both the size and style factors, Gunzberg says.

Large Caps Are Less Volatile

Large-cap stocks, with a market value of $10 billion or more, make up at least 70% of all stocks, tend to be more stable, are often household names and are blue-chip stocks such as Microsoft Corp. (MSFT), Johnson & Johnson (JNJ) and Exxon Mobil Corp. (XOM).

“Large and mid caps tend to be multinational companies, which could open up your portfolio to risks abroad,” says Loewengart. “For most investors, a mix of market caps makes sense, diversification can help serve as a buffer during times of market volatility.”

Large-cap stocks tend to be less volatile during turbulent markets as investors “move to quality and stability and become more risk-averse,” Michelson says.

One major drawback of large-cap stocks is that businesses tend to grow more slowly than mid-cap companies because of their size. The advantage is that many large-cap stocks pay dividends, “providing a source of income and a financial reason to purchase shares,” he says.

In 2009, at the tail end of the Great Recession, small caps underperformed compared with mid caps and large caps. But in 2016, the opposite was true – small caps far outperformed large caps and mid caps, Michelson says.

During extended periods, mid caps tend to outperform both small and large-cap stocks, he says.

“The greatest risk is not being diversified, such as being overweighted in small-cap stocks and then possibly experiencing several years of underperformance,” Michelson says.

On the upside, Michelson adds that large-cap funds typically have lower expense ratios, effectively increasing net return.

Large caps also have the highest dividend yield but not by much unless an investor is looking at growth stocks, experts say.

Diversification of Cap Size Matters

One way to diversify risk and attain a reasonable long-term return is for an investor to consider a portfolio consisting of 25% large caps, 25% mid caps and 20% small caps, Michelson says.

“This diversified portfolio allows an investor to maintain the stability of large caps, the long-term returns of mid caps, and the higher returns along with the higher risk of small caps,” he says. “The remaining 30% of the portfolio should be invested in international stocks and bonds for further diversification.”

Having a good mix of market caps is critical and ensures that a portfolio does not face steep losses because U.S. equity performance varies vastly annually by size, Gunzberg says.

When growth is occurring in the U.S. and the dollar is also rising, small-cap stocks are a safer bet, Gunzberg says. On the flip side, mid-cap companies tend to perform better with a falling dollar from growth opportunities overseas, but large caps are the most sensitive to global tensions but also have the greatest ability to hedge, she says.

In short, investors must evaluate economic conditions to determine the right amount of allocation, in terms of caps, for their portfolio.

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