A Cap-ital Idea

Rick Welch |

The value of a publicly traded company is often referred to as market capitalization (or market cap) and is calculated by multiplying the share price times the number of outstanding shares of stock.  Typically, companies are divided into four market cap classifications: mega-cap, 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 mega-cap as above $200 billion, large-cap as between $10 and $200 billion, mid-cap as between $2 and $10 billion and small-cap as between $300 million and $2 billion.   Do not be surprised if you see additional cap classifications like micro-cap (below $300 million) and nano-cap (below $50 million).

How important is market capitalization in the decision to add a stock to my portfolio? Very important.  We advise our clients to consider market cap first, then sector and then style.  In making 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.  Secondly, we consider how the relationship between large-caps and small-caps affects the level of diversification within a portfolio. Lastly, we must determine the appropriate allocation to large and small-cap stocks within a portfolio.

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.  When we look at the rankings of the largest US companies it should come as no surprise that we see Apple ($2.4 trillion), Microsoft ($2.0 trillion) and Google ($1.5 trillion) at the top. Just how big is Apple? Its market cap of $2.4 trillion is equal to about 1/3 of the market cap of the entire Russell 2000! As market leaders, large cap companies often experience a slower growth trajectory and over time can begin to look more like value stocks than  growth stocks.  An important bonus for investors is that many large cap companies pay a quarterly dividend, a much appreciated source of income for all investors.  Small-cap companies offer uncharted territory, increased risk and the realization that price appreciation is often based on the expectation of significant future growth, not strong earnings history.  With this increased risk comes the potential for higher investment returns.   Owners of small-cap stocks receive little or no dividend and also face increased share price volatility (higher highs and lower lows).

Large and small-cap stocks tend to move together over time but can still 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.  The high correlation (0.89) of US large and small-cap stocks means that adding small-caps to your portfolio improves diversification only slightly.  Over the past 10 years US Large Caps have returned, on average +17.15 per year, compared to a return for US Small Caps of +14.1%. In the 3 years (out of 10) in which small caps outperformed large caps we saw a differential of +5.73%. How much an investor allocates to small-caps is dependent on his/her risk profile.  In general, within your US stock holdings, it may be appropriate to allocate 80% to large-caps and 20% to small-caps.