Why Is Market Capitalization Important to an Investor?

This is the second in a series covering some of the words used to describe different aspects of the stock market. The characteristics of and differences between domestic markets, international markets, emerging markets, and developed markets were covered in the first blog, Are Stock Market Descriptions Confusing?

Today I will cover the importance of market capitalization (often shortened to market cap) – the total dollar market value of the outstanding shares of a stock.

On average, large-cap corporations – those with market capitalizations of $10 billion and greater – tend to grow more slowly than mid-cap companies. Mid-cap companies are those with a capitalization between $2 billion and $10 billion, while small-cap corporations have capitalization between $250 million and $2 billion. The dividing lines change from time to time, but the characteristics remain. Historically, market capitalization has an inverse or opposite relationship to both risk and return.

Large Caps

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. As a result, they are often considered the safest equity (stock) investments. Basically, large-cap stocks are large companies. A few well-known US companies that are large-cap stocks include Microsoft (MSFT), Apple (AAPL), Amazon (AMZN), Alphabet (GOOGL) and Meta (META). While there are more mid- and small-cap companies, large-cap companies have a higher total market value.

The stock of large-cap companies, often referred to as blue-chip stocks, share other characteristics. For example, they often pay dividends to their investors in addition to the returns through price appreciation. The companies are typically financially sound and have a track record of consistent growth and profitability. They have established themselves as market leaders.

The management teams and leadership boards of large-cap companies often have years of combined experience which provides stability. Also, information is readily available for investors to review and analyze. Earnings reports, for example, offer a degree of transparency that can be helpful when making buy and sell decisions for a particular stock. Professional stock analyzers follow these companies and issue regular assessments to investors.

Mid and Small Caps

Shares of small caps and mid caps may be more affordable for investors than large caps, but smaller stocks also tend to have greater price volatility.

Mid-Cap Stocks

The market capitalization range for mid-cap stocks – $2 to $10 billion – is broader than that of small-cap and large-cap stocks. Examples of US mid-cap stocks are American Airlines (AAL), AutoNation (AN), and US Steel (X). Mid-cap companies operate in a wide range of industries and are often expanding and developing new products and services in many geographic areas. They have a strong foothold in their respective industries but still have significant room for growth as they take advantage of emerging trends and opportunities.

The risk profile of mid-cap stocks is less than small companies but more than large companies. As a result, the return potential would be expected to be in between the two as well.

Small-Cap Stocks

Small -ap companies – $250 million to $2 billion – are those that are typically in the early stages of their existence, however some familiar names are on this list also. Examples of small-cap companies in the US are JetBlue Airways (JBLU), The Cheesecake Factory (CAKE), LegalZoom (LZ), Camping World Holdings (CWH), and IMAX Corporation (IMAX). Because the value of small-cap stocks has more room to grow than mid- or large-cap stocks, their percentage returns have the potential to be higher. Their share prices are usually lower as well, as they’re not worth as much as larger companies.

Although small-cap companies may climb the ranks to mid cap or even large cap, they’re inherently riskier than larger companies. Less information is available to the public and even financial data may be harder to find. Fewer professional stock analysts follow a particular company, or a company may not be analyzed at all.

Small-cap stocks are susceptible to volatility due to their size. Bankruptcy is a greater possibility than with larger companies. Younger firms are bringing new products and services to the market or creating entirely new markets. Much of a small-cap’s valuation is based on its potential to grow. For this to happen, it must be able to scale its business model. Small-cap companies tend to have smaller customer bases, so their prospects are more uncertain and often tied to a specific geographical area. As a result, many small-cap stocks are unable to survive through the rough parts of a normal business cycle.

Diversification

Most financial advisors will create a portfolio with a combination of large, mid, and small-cap stock holdings. That somewhat tempers the growth potential of small and mid caps with more stability from large-cap stock. The overall volatility of the stock portfolio is reduced but there is still potential for growth, which is the primary reason for investing in stock.

Large-cap stocks carry a greater possibility of income in the form of dividends which enhances their return. Of course, some mid- and small-cap companies also pay dividends. Their primary focus, however, is to reinvest profits in product development and market growth.

If you decide to invest in individual stocks, be prepared to spend a considerable amount of time on research. Put any recommendations that you hear or read about through the funnel of “what is right for me and my circumstances.” If you decide to take the mutual fund or exchange-traded fund (ETF) approach to investing, a professional will manage the individual stock choice for you.

Neither method is right or wrong, but your time commitment will be different. Many investors combine the two approaches with a portfolio mainly comprised of mutual funds and/or ETFs with a few individual stocks in companies that are especially interesting and that they will follow closely. Your choice! Have fun!

Let’s Have a Conversation:

Are you a new investor or have you done some investing in the past? How did you start? What have you learned about each of the three types of stocks? How diverse is your current portfolio? Do you manage it yourself or trust an advisor?

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