Sometimes, we in the financial services industry get so immersed in what we do that we kind of forget that the rest of the world may not understand about the terminology we use. In other words, we tend to throw around lingo without checking to ensure that we are being understood. That’s not a concern when our audience stops us to ask for clarification, but that doesn’t always happen. In any case, the onus should be on us to communicate effectively, right?
With that in mind, I’m going to review a fundamental stock market investing concept that we advisors throw around a lot. That concept is the market capitalization of a stock. The market cap is a number that describes the overall market value of a stock, and is one measure of how big a company is. The specific calculation is simply the price of a stock multiplied by the number of shares outstanding. These are the shares that are held by investors. For example, Intel has 4.97 billion shares outstanding, and as I write this the stock is trading for $24.71 per share. Intel’s market cap is therefore $122.18 billion. If you wanted to be the sole owner of Intel, and were able to purchase all of the outstanding shares without changing the market price, you’d have to come up with just over $122 billion to own the company. There are other barriers to snapping up all of the shares at that value, but let’s ignore them for now, as I suspect that it’s unnecessary for me to warn against trying to do this.
How Big is Large?
When we’re discussing asset allocation, or the types of investments within a portfolio, advisors tend to describe market cap in terms of Small, Mid and Large. You’ll sometimes hear variations on this theme, with terms such as nano cap, micro cap and mega cap. To be clear, these are generalized terms, and there’s no universal, specific definition of each category. Generally, though, small cap stocks are taken to be those with market caps under $2 billion. The most common interpretation of the low-end for these companies is probably $250 million, although that’s a pretty small publicly-traded company. Given that definition of small-cap, mid-cap companies would typically be in the $2 billion to $10 billion range, and large-cap companies would be everything larger than that.
In practice, especially when indexes are created based on these categorizations, the above definitions roughly hold true, but the individual stocks are often measured relative to each other, rather than against an arbitrary value. An example might highlight why this makes sense. One commonly held definition of mega-cap stocks is those that have a market value greater than $200 billion. There just are not that many companies that are that big. Imagine how many there were in early 2009, at the bottom of the market’s plunge. Not many at all.
Buying and selling stocks based on a relative value rather than an arbitrary dollar figure is probably wise, because adhering to specific values would force trades that might not otherwise make sense. For instance, if a fund can only hold mega-cap stocks, and it defines mega-cap as all companies with a market cap greater than $200 billion, it may own 20 stocks at a given point in time. If the overall market drops by 20%, the number of these mega-cap stocks, may decrease because the values of some of those companies have temporarily dropped. The fund would then have to sell those names at a time when prices are relatively low. In this case, the absolute value of $200 billion would actually force the fund to buy high and sell low!
Why Should You Care How Big a Company Is?
Although the lines between them might be a bit fuzzy at the margins, it is clear that large companies as a group perform differently than small companies over time. Large-cap companies may be that way because they’ve grown to that size over a long period of time, and thus they’ve demonstrated staying power. Certainly, they tend to be less volatile than companies with smaller capitalizations. On the other hand, small-cap companies are sometimes in the early stages of becoming much bigger firms, and thus they have a lot of room to grow earnings, which may make them more attractive in terms of future price appreciation. There are many other nuances that highlight the importance of knowing the market capitalization characteristics of a stock or grouping of stocks that you may be considering.
Big or small, it’s important to know what you’re buying, and why.