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All About Market Capitalization |
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Big caps. Mid-caps. Small caps. Market capitalization. You've heard these terms tossed about by the media and at cocktail parties.
As an investor, here is what you need to know about them:
First, don't be intimidated by the term "market capitalization." It's nothing more than another way of saying what the market value of a company's outstanding shares is worth at any given time.
Second, if you want to calculate a company's market capitalization, take the number of outstanding shares and multiply it by the stock's price. A company's outstanding shares (also known as issued shares) are the number of shares held by the general public as well as by the officers of the corporation.
Suppose, for instance, ABC Company sells for $10 a share with 10 million shares outstanding. Its market capitalization would be $100 million dollars (i.e., $10 per share times 10 million shares).
Third, there are no exact definitions for what constitutes big-cap, mid-cap, and small-cap stocks. The definitions change over time and vary from one brokerage house to another. Nonetheless, there is a rough-and-ready consensus as to how to differentiate them:
1. Large Caps: A large cap is generally regarded as having a market capitalization of more than $10 billion dollars.
2. Mid-Caps: A mid-cap stock has a capitalization that is less than that of a large cap but greater than that of a small cap.
3. Small Caps: A small cap is typically defined as a company capitalized with less than $2 billion but more than $250 million. Companies with capitalizations under $250 million are called micro caps.
- Large Caps
Investing in large-cap stocks has its advantages. They are typically stable companies able to generate sustained profits over time. They also often have a history of dividend payments, which makes them attractive to retirees who need a steady flow of income and people who like getting a cash payment four times a year.
When a bull market is well underway, large caps offer excellent earnings growth. On the other hand, they are simply too big to take off hard and fast like smaller companies, even when times are good. But in a bear market, they have the resources and deep pockets to endure the ravages of a general market decline better than companies with smaller capitalizations.
Large-caps stocks work well for technical traders who concentrate on the price action of a stock and largely ignore its fundamentals. Because they are heavily traded, large-cap stocks permit traders to enter and exit the market at favorable prices.
Large-cap stocks are the darlings of Wall Street. At least part of their appeal on Wall Street lies in the fact that, for some time, brokerage houses have been deriving their greatest profits from their biggest investment banking deals -- which, not surprisingly, involve the biggest companies.
Yet, what is in Wall Street's best interest may not be in yours. Large caps are fine investments if carefully chosen and followed. But massive capitalization is no guarantee of a stock's continued success. While not a frequent occurrence, large-cap companies can fail and go bankrupt just like less well-endowed companies. (Think of Enron and WorldCom.) And although they can usually outperform lesser-capitalized stocks in a bear market, they will almost always suffer along with the rest of the general market.
So if your broker suggests a large-cap stock, check to see if his brokerage house has any sort of relationship with the company he is touting. (See "Word to the Wise," below.) If the brokerage is underwriting a new issuance of the company's stock or otherwise substantially working on behalf of the company, consider it a red flag. Ask the broker if there is any relationship (by law, he has to tell you the truth) and double-check by doing a quick online search of the company at either the yahoo financial site (http://finance.yahoo.com) or the CBS financial site (http://cbs.marketwatch.com).
- Mid-Caps
With mid-caps, you get the best of both worlds. You get all the advantages of a large-cap stock (e.g., stability and the advantages of a small-cap stock (e.g., growth).
Mid-cap companies have sometimes been disparaged because they are very often small-cap companies that never made the big leagues or large-cap companies that suffered through a period of decline and downsizing. In other words, they may be companies that are nothing more than once-upon-a-time contenders in the marketplace. Their failure to emerge as market leaders could suggest ongoing problems. On the other hand, mid-cap companies can deliver better returns than either large-cap or small-cap stocks. IMS Capital Management says that over the past 20 years, mid-caps enjoyed a higher overall return than either large or small caps.
- Small Caps
Every large-cap company began as a small-cap company. And that is the average investor's secret hope when investing in small caps.
Small caps give you a chance to beat the big boys at their own game. There are plenty of relatively small, deeply undervalued stocks with solid fundamentals, waiting to make investors wealthy.
The majority of analysts at most brokerage houses don't follow small-cap stocks. Therefore, very few people know about them. They are sometimes off the radar screen of even the shrewdest investors.
Equally important, mutual funds and other large institutional investors are often unable to buy small-cap stocks, because to do so would violate their charters that prohibit them from taking too large a position in any one company. They can, of course, ask the Securities & Exchange Commission for an exemption. But doing that would only alert everyone to the fact that the fund was about to buy the stock. That would cause the stock's price to surge as other investors flock to buy in anticipation of the fund's getting approval. As a result, the fund ends up buying the stock at an unfavorable price.
This means that when it comes to small caps, you, as a small investor, have a definite advantage over the big money. That said, here are a few cautionary principles to take to heart before you chase small-cap stocks.
Don't get involved in picking small-cap stocks unless you've done your homework. Researching small-caps requires time. You must know how to read income and balance sheets. And you need to have a thorough understanding of financial ratios (price-to-earnings, debt-to-equity, price-to-sales, book value, leverage, and the like).
Even if you choose to use technical analysis (focusing primarily on price action at the expense of a company's or sector's fundamentals) to help you invest, you have to make sure your trading system works with stocks that are characterized by relatively low volume and wild price swings. Getting good fills -- in other words, paying a reasonable price as you try to enter and exit the market -- can be frustrating and even costly.
Prepare yourself, psychologically, for these price fluctuations. Don't invest in small caps if you can't sleep soundly at night wondering if your investment will lose 10% of its value at the opening bell the next morning. (It has been known to happen.)
Don't expect to get rich overnight investing in small caps. Investing in small caps requires patience and discipline. Yes, there are rare exceptions -- but they depend as much on luck as on the company's performance or your skill as a stock picker. Small caps take time to grow and develop a reputation before they attract the attention of the financial community. The good news is that when they succeed, they usually succeed marvelously.
Putting Capitalization to Work in Your Portfolio
Market capitalization should not be a primary criterion in choosing a stock. Money management and an unwavering focus on the performance prospects of the company are far more important. Still, you shouldn't ignore the role market capitalization can play in your portfolio decision-making. It can help you better identify and control the risks you are taking. The next time you are looking to buy a stock, you may want to consider the following options:
If you stay in stocks during a bear market, you may want to put your money in financially sound, large-cap stocks that can weather lower profit margins and higher interest rates better than small caps.
Alternately, you might want to invest in undervalued, small-cap stocks and ride the bear market out. The advantage here is that when the market reverses direction, your stock may be one of the first ones out of the gate as the market rallies. But it's also possible that the company will be so beaten up by the bear market that its stock won't be able to rebound.
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