Investing in a Company Size
“When it comes to the stock market, the bigger they are…the softer they fall”
As mentioned in Lesson 2, there’s more to diversification than just having a variety of stocks. You should also consider diversifying by type of company, location of company, and by size of company. Diversifying by size of company requires that you understand how companies are sized in the market.
In this section, you’ll learn…
- How companies are sized in the market
- Why stocks of large, established companies provide a solid and dependable foundation in any portfolio
- The pitfalls and potential rewards of investing in smaller-sized companies
Whether you are a more experienced investor or just starting out, it often makes sense to make the stocks of large, established companies the cornerstone of your portfolio. They provide a good, solid and dependable base on which to concentrate your efforts.
Large-sized companies are large for a reason – the core one being they’ve achieved their status through consistently strong performance year-over-year. Large-sized companies are generally leaders in their product market, are more protected through market downturns, and have a much lower risk of going out of business in the long-term.
Large established companies make good cornerstones for an investment portfolio.
Larger companies are also more likely to dish out some of their profits in the form of dividends. This is simply a distribution to shareholders of some of the earnings of the company. A dividend can help boost your portfolio’s overall return. Dividends are also good for cushioning the blow when stock prices fall. If you have a stock paying a dividend of 2.5 per cent a year, and the stock price doesn’t budge a penny, you’ve still made a decent – if small – return.
Having said this, smaller-sized companies can be good investments to have in your portfolio as a vehicle to help maximize returns. Therefore, it does pay to familiarize yourself with how companies are “sized”, and their different characteristics.
How Company’s Are Sized
Just as you buy pants by their leg length, and footwear depending on your shoe size, there is a specialized system for measuring the size of publicly traded companies.
Companies are measured in terms of what they are going for in the open market. In other words, what the combined intelligence of all the investors in the world figure that particular company is worth at a present point in time.
And that number is very straightforward…the number of shares outstanding multiplied by the current share price. This is the company’s market capitalization, or “market cap” in investor-speak.
The Three “Market Cap” Sizes: Small, Medium, and Large
Just like everything from cups of coffee to sweatshirts, companies come in three basic sizes – small, medium, and large. All you have to do is throw in the word “cap” at the end and you too can sound like a million-dollar-a-year stock guru.
Did You Know…
The term ‘blue chip’ originated in 1929 from the card game Poker that uses colored, circular chips to denote currency. Among the colored chips used, the blue chips represented the highest value. The term carried over to the stock market with blue chips referring to stocks of the largest, most valuable companies.
Here are the definitions for the three different sizes of companies:
Small-cap stocks: These are shares of small, publicly traded companies. In this case, ‘small’ is typically defined as having a market capitalization of under $1 billion. The most common measurement of how small-cap stocks are faring is the Russell 2000 index.
Mid-cap stocks: These are shares of medium-sized companies. Typically, this means companies that have a market capitalization of between $1 billion and $5 billion. One popular benchmark for mid-cap stocks is the S&P MidCap 400.
Large-cap stocks: These are shares of the largest-sized companies. Large cap stocks are often referred to as blue chip stocks. Large companies are generally accepted as those with a market capitalization of at least $5 billion or more. The Dow Jones Industrial Average is the most common measurement of large-cap stocks, and is composed solely of large-cap companies.
Smaller Companies: Higher Risks, Higher Rewards
There is an undeniable rule about risk and how it relates to investments – the higher the potential returns, the greater the risk. Conversely, the lower the risk, the less the potential for returns.
Although larger companies provide greater stability, the potential rewards are lower due to that stability. Smaller companies can provide higher rates of return, but are a more risky investment due to their higher reward potential.
The Pitfalls of Investing In Smaller Companies
- Small companies tend to have fewer financial resources backing them. That means they may not be able to see themselves through a cash-flow squeeze.
- They also usually have fewer products or services. If sales drop off in a key product, or a competitor leapfrogs past, the entire company may take a body blow.
- Smaller businesses are often just getting the wrinkles worked out of their administration, management, and other key areas.
- Another problem small companies face is managing their own success. Even if their product or service catches on, adding the administrative, sales, and marketing capabilities to satisfy expanding sales is a challenge in itself – one some companies stumble over.
- They have fewer shares outstanding – and the number of shares typically traded in any one day is usually a fraction of that of large-cap companies.
Don’t over estimate your gut’s ability to evaluate risk. Our perception of risk is often far different than the actual likelihood of something happening or not happening.
The Upside of Investing In Smaller Companies
While small-cap stocks are more volatile than large-caps stocks, that volatility often rewards investors with large-scale returns.
Smaller companies have greater potential for reward because:
- The stocks of smaller companies simply get less exposure and publicity. This lack of attention and information means you may be able to find small-cap stocks that are trading at deep discounts compared to more well-known companies.
- Small-cap stocks get followed by fewer stock analysts – people who are paid to assess stocks and advise individual and institutional investors on whether they are good investments or not. This lack of analysis can depress a small-cap stock’s pricing, but also open up opportunities when analyst interest turns its way.
- The people in charge of the company such as the president and senior managers – known as insiders in the financial world – often own a large percentage of the shares available. This gives them a lot of motivation to help the shares perform well.
The people in charge of the company such as the president and senior managers are known as insiders in the financial world.
Key Learning Points
- One way of categorizing stocks is by size of the company. Size is measured in terms of a company’s market capitalization – its current share price multiplied by the number of shares outstanding.
- Small-cap stocks are those belonging to companies worth under $1 billion. Mid-cap stocks are those of company’s worth between $1 billion and $5 billion. The stocks of companies with a market capitalization of over $5 billion are known as large-caps.
- It’s generally best to make large-cap stocks the cornerstone of your stock portfolio. Large-cap companies have the financial resources to weather corporate and economic downturns. They also have a wider range of products and customers. Finally, their long-term track records helps to ensure future success.
- Small-cap stocks typically carry higher risk. Small-caps are riskier because they are traded less frequently, have fewer products and customers, and often have to struggle with managing their growth.
- Small-cap stocks can also offer higher returns. This is because they may have previously been unnoticed by the market, and may therefore be priced at a discount. Also management, due to holding a large amount of shares, is highly motivated to see the share price rise.