Everyone loves a good underdog story, right? Small cap vs. large cap stocks might seem like a battle of David vs Goliath considering the size of some of the biggest US companies right now, but sometimes being small has its advantages. No one starts as a huge multinational conglomerate – even companies like Amazon and Microsoft got started in garages.
Stocks are sliced up and categorized in many different ways. Sometimes it’s by sector, other times by country or location, and sometimes it’s done by company size. When investors discuss small cap or large cap stocks, what they’re referring to is the market capitalization of the company. Market cap is used to measure the size of companies and is utilized to create indices like the S&P 500 (and the many ETFs and mutual funds that track it).
What Is Market Capitalization?
Market capitalization is the total value of all shares of a publicly-traded company. Figuring out a company’s market cap doesn’t require a complex formula, you just multiply the number of shares by the price of the stock.
For example, Amazon is priced at $3087.85 (as of February 28th, 2021) and has 503.56M shares outstanding. If we multiply the share price by the total number of outstanding shares, we get $1.557 trillion – the total market cap of Amazon stock. Market cap is a proxy for company size since not all large cap companies have the same number of employees, nor do they pull in the same numbers in revenue. Microsoft is larger than Amazon by market cap ($1.75 trillion vs $1.5 trillion) despite the fact that Microsoft’s 4Q revenue was about ⅓ of the revenue Amazon tallied in Q4.
Market cap is used to divide stocks into groups like micro caps, small caps, mid caps, and large caps. Investing in stocks by market cap is a common method used to smooth risk in a portfolio. Large cap stocks tend to be safer, more established companies while small caps are often new and volatile firms. Market cap is an easy and effective way to valuing the total worth of a company.
What Are Large Cap Stocks?
Large cap stocks are the biggest and most successful companies in the stock market. No one starts as a large cap – these are the firms that have stood the test of time and not sit firmly at the top of the food chain.
To be considered a large cap, the company usually must have a market capitalization of over $10 billion. Large cap stocks are usually found at the top of the financial media headlines and their earnings reports are big news. Right now, the five largest stocks by market cap are:
- Apple (NYSE: AAPL)
- Microsoft (NYSE: MSFT)
- Amazon (NYSE: AMZN)
- Google (NYSE: GOOG)
- Facebook (NYSE: FB)
Advantages/Disadvantages of Large Cap Stocks
Large cap stocks are usually safe, blue-chip investments that can be counted on for capital appreciation. They have a history of success and an unavoidable footprint in the market. Large cap stocks usually pay dividends too, but there are drawbacks to investing in large caps.
Since large cap companies have already achieved massive success, there are often questions about how much more growth is available to these companies. Large cap companies are the entrenched players, but their growth rates are usually slowing and they return capital to shareholders via dividends instead of investing for more expansion or R&D. There’s safety in large cap investments, but you’re unlikely to see parabolic returns.
What Are Small Cap Stocks?
Small cap stocks pale in comparison to large caps when it comes to market capitalization, but “small’ and “large” are still relative terms here. A small cap company can often have a market cap close to $2 billion, which hardly counts as ‘small’ in the eyes of most normal people. The range for small cap stocks is usually $300 million to $2 billion, with stocks under $300 million classified as micro caps.
Small cap stocks have been riskier than large caps simply because of the uncertainty involved with these types of companies. Small caps are often taking on entrenched large cap players in their industries and the rate of failure is high. Of course, small cap stocks that achieve success can also reward investors with meteoric rises. For example, you may have heard about a small cap retailer called GameStop (NYSE: GME) on the news lately. With greater risk come greater rewards, but investors should be acutely aware of pros and cons of small caps before investing.
Are Small Cap Stocks Always Start-Ups?
There’s often a common misconception that small caps are new startup companies trying to score large growth. This isn’t entirely true – not every company has the goal of becoming one of the largest players in the S&P 500.
Some small cap firms are happy to stay small and provide shareholders with profits, such as finance firms like Fidus Investment Corp (NYSE: FDUS) which pays an 8% dividend despite having a market cap just north of $300 million. Other small cap companies like Winnebago Industries (NYSE: WGO) have a good selling product in a niche market and realize overexpansion would hurt their bottom line.
Advantages/Disadvantages of Investing in Small Cap Stocks
The biggest advantage of investing in small caps is the potential of exponential growth. Small cap companies that win government contracts, grow sales, or expand market share can be rewarded with parabolic share movement. The next Amazon or Facebook won’t come from a list of established large cap firms – it’ll be a small cap company most investors have never heard of.
Small caps also have more risks. They aren’t as transparent as large cap companies, nor are they flushed with cash. A bad earnings report or failed drug trial can send the value of a small cap stock plummeting. That’s why most advisors recommend investing in small caps through ETFs, so you can limit the impact of the failures while also reaping upside benefits.
- Growth: Large cap stocks are at the top of their fields or industries and often have reached the limits of their growth. Large caps are often more concerned with returning capital to shareholders while small caps are more focused on growing and expanding market share.
- Investment Risks: Since small cap stocks are often new companies attempting to establish themselves, they’re more prone to negative events like bankruptcies, product delays, or earnings misses. Small caps are far more volatile than their large cap cousins and investors should be prepared for the see-saw if they invest in smaller firms.
- Dividends: Small caps are usually obsessed with growth, which means plowing profits into expansion and R&D. Less growth-focused large caps are more apt to return profits to shareholders through dividends or buybacks.
Large cap vs. small cap stocks might sound like an underdog story, but they really aren’t fighting against each other in your portfolio. While different size companies compete across many different industries, small cap and large cap stocks BOTH have a role in your investment plans. A diversified portfolio can dedicate a portion to small caps in order to capture the exponential growth found in that asset class while also having large cap stock holdings for capital preservation and income through dividends. You’ll need to use your own investment goals and risk tolerance to determine the proper allocation of large caps vs small caps.
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