Small Cap Stocks vs. Large Cap Stocks: An Overview
Historically, market capitalization, defined as the value of all outstanding shares of a corporation, has an inverse or opposite relationship to both risk and return. On average, large-cap corporations—those with market capitalizations of US$10 billion and greater—tend to grow more slowly than mid-cap companies. Mid-cap companies are those with capitalization between $2 and $10 billion, while small-cap corporations have between $300 million and $2 billion. These definitions of large cap and small cap differ slightly between the brokerage houses, and the dividing lines have shifted over time. The differing definitions are relatively superficial and only matter for the companies that are on the borderlines.
- Publicly traded companies are often segmented by their market capitalization - that is, the total value of their shares in the market,
- Large-cap corporations, or those with larger market capitalizations of $10 billion or more, tend to grow more slowly than small caps, which have values between $250 million and $2 billion.
- Large caps tend to be more mature companies, and so are less volatile during rough markets as investors fly to quality and become more risk-averse.
- Small caps and midcaps are more affordable than large caps, but volatility in these markets points to large-cap leadership in 2019.
Understanding Small vs. Big-Cap Stocks
Small Cap Stocks
Small cap stocks have fewer publicly-traded shares than mid or large-cap companies. As mentioned earlier, these businesses have between $300 million and $2 billion of the total dollar value of all outstanding shares—those held by investors, institutional investors, and company insiders.
Smaller businesses will float smaller offerings of shares. So, these stocks may be thinly traded and it may take longer for their transactions to finalize. However, the small-cap marketplace is one place where the individual investor has an advantage over institutional investors. Since they buy large blocks of stocks, institutional investors do not involve themselves as frequently in small-cap offerings. If they did, they would find themselves owning controlling portions of these smaller businesses.
Lack of liquidity remains a struggle for small-cap stocks, especially for investors who take pride in building their portfolios on diversification. This difference has two effects:
- Small cap investors may struggle to offload shares. When there is less liquidity in a marketplace, an investor may find it takes longer to buy or sell a particular holding with little daily trading volume.
- The managers of small-cap funds close their funds to new investors at lower assets under management (AUM) thresholds.
Lack of liquidity remains a struggle for small caps, especially for investors who take pride in building their portfolios on diversification.
Large Cap Stocks
Large-cap stocks—also known as big caps—are shares that trade for corporations with a market capitalization of $10 billion or more. Large-cap stocks tend to be less volatile during rough markets as investors fly to quality and stability and become more risk-averse. These companies comprise over 90% of the American equities marketplace and include names such as mobile communications giant Apple (AAPL), multinational conglomerate Berkshire Hathaway (BRK.A), and oil and gas colossus Exxon Mobil (XOM). Many indices and benchmarks follow large-cap companies such as the Dow Jones Industrial Average (DJIA) and the Standard and Poor's 500 (S&P 500).
Since large cap stocks represent the majority of the U.S. equity market, they are often looked to as core portfolio investments. Characteristics often associated with large cap stocks include the following:
- Transparent: Large cap companies are typically transparent, making it easy for investors to find and analyze public information about them.
- Dividend payers: Large cap, stable, established companies are often the companies investors choose for dividend income distributions. Their mature market establishment has allowed them to establish and commit to high dividend payout ratios.
- Stable and impactful: Large cap stocks are typically blue chip companies at peak business cycle phases, generating established and stable revenue and earnings. They tend to move with the market economy because of their size. They are also market leaders. They produce innovative solutions often with global market operations, and market news about these companies is typically impactful to the broad market overall.
There is a decided advantage for large caps in terms of liquidity and research coverage. Large-cap offerings have a strong following, and there is an abundance of company financials, independent research, and market data available for investors to review. Additionally, large caps tend to operate with more market efficiency—trading at prices that reflect the underlying company—also, they trade at higher volumes than their smaller cousins.
Small cap stocks tend to be more volatile and riskier investments. Small-cap firms generally have less access to capital and, overall, not as many financial resources. This makes it difficult for smaller companies to obtain the necessary financing to bridge gaps in cash flow, fund new market growth pursuits, or undertake large capital expenditures. This problem can become more severe for small-cap companies during lows in the economic cycle.
Despite the additional risk of small-cap stocks, there are good arguments for investing in them. One advantage is that it is easier for small companies to generate proportionately large growth rates. Sales of $500,000 can be doubled a lot more easily than sales of $5 million. Also, since a small, intimate managerial staff often runs smaller companies, they can more quickly adapt to changing market conditions in somewhat the same way it is easier for a small boat to change course than it is for a large ocean liner.
Likewise, large-cap stocks are not always ideal. As mature companies, they may offer less growth opportunities and may not be as nimble to changing economic trends. Indeed, several large companies have experienced turmoil and have lost favor. Just because it's a large cap, doesn't mean it's always a great investment. You still have to do your research, which means looking at other, smaller companies which can provide you with a great basis for your overall investment portfolio.
Volatility struck small caps in late 2018, although this is not a new phenomenon. Small cap stocks did well in the first three quarters of 2018, entering September of that year with the Russell 2000 index up 13.4% compared to 8.5% for the S&P 500. Between 1980 and 2015, small caps averaged 11.24% annual growth in the face of rising interest rates, easily outpacing midcaps at 8.59% and large caps at 8.00%. In the first weeks of 2019, the Russell 2000 led the market by 7% to the S&P 500’s 3.7%.