Small cap stocks and large-cap stocks, what does it mean and what is the difference?
How to choose between the two types and decide whether small cap stocks are good investment.
Small cap and big cap are terms used to distinguish the size of a publicly-traded company based on its market capitalisation. Market capitalization is the total market value of a company’s outstanding shares. It is equal to the share price multiplied by the number of shares outstanding and is frequently referred to as market cap.
Market cap measures what a company is worth on the open market based on public perception and what investors are willing to pay for it. It is a valuable evaluation tool as it allows investors to understand the relative size of a company in comparison to others. It is frequently used to make broad assumptions about how a business will grow and perform in the future.
The definition of small and big cap companies can vary slightly from one person or organisation to the next but typically large cap stocks have a market capitalisation larger than $10bn. Small cap stocks start at $250m or $300m - $2bn and mid cap stocks are between the two at $2 -$10bn. As market capitalisation is mainly used to compare the size of a company relative to another the borders do not necessarily need to be sharply defined.
What is a small cap stock?
The term small cap may be misleading and what is a small cap stock can vary significantly as these stocks can have a market capitalisation of anywhere from $250m or $300m up to $2bn. As mentioned early the classification is used mainly for comparison as a company valued at $250m will not necessarily share many characteristics with a company valued at $2bn. Likewise, a company at the upper threshold of the definition will likely share more similarities with mid cap stocks than it does with lower end small cap stocks. Market capitalisation should always be a part of a much more thorough analysis.
Small cap shares are considered to be more aggressive and therefore riskier than large cap stocks with their smaller relative size potentially making them more susceptible to fluctuations in the market. Others may argue that their smaller relative size makes them more agile, with the ability to more quickly adjust to changing market conditions. This has also proven true in certain instances but broadly speaking they are less likely to successfully negotiate a significant downturn in the economy.
Small cap stocks are more vulnerable to the influence of outside competition as they generally have not cemented themselves in a market or industry the way large cap stock companies have. Small cap stocks are generally younger than large cap stocks and this does provide a stronger potential for growth if they are successful. If you think about it, large cap stocks were at one time small cap stocks and the ones that get it right grew tremendously.
Small cap stocks normally have a smaller number of publicly traded shares and this can be an advantage to the individual investor. Institutional investors like to purchase large blocks of shares and they can find that difficult to do without taking a controlling interest in small cap companies. It may be impossible to make the size of investment they typically do without taking a majority or at least significant percentage of a company and potentially voting rights. Small cap stocks can experience liquidity problems and traders should consider average daily trading volumes before purchasing a specific stock.
What is a large cap stock?
Large cap stocks are companies which have a market capitalisation above $10bn. These companies dominate American stock exchanges such as the Nasdaq and NYSE and are typically very well established. There are some relatively new companies that reach this size quickly, particularly in the tech industry. Most large cap stocks are well known names such as GE and Coca-Cola. However, not all large cap stocks are a household name, but they are significantly entrenched in their respective industries. They are considered less risky than small cap stocks as they have the resources available to react to any unforeseen market developments. This reduced risk does typically come at the expense of less rapid growth although large cap companies are recognised for their steady long-term growth.
What are the key differences?
Small cap vs large cap stocks vary considerably based on the individual company but there are some general differences between the two. These are:
Small cap stocks are typically younger and due to their relatively small size they are in a better position for fast and aggressive growth. This can provide significant returns to the investor. The goal of small cap stocks is usually, not always, to become a mid or large cap stock and they are looking for the fastest route.
Large cap stocks are interested in growth but they more so lean towards long term and steady growth. They are typically market leaders in their industry and are the size that they are focused on strategic outcomes. They will have a strong historical track record for an investor to base their decision. They are considered a safer investment and the assumption that they do not have the same potential for significant growth in the short-term.
Large cap stocks are less susceptible to fluctuation in a volatile market and have vast resources to buffer any negative turns in the economy. This does not mean that they are invincible to downturns or recessions, but they are significantly better equipped to manage them than small cap companies. Large cap stocks are also usually much more liquid than small cap shares and in the event of a sudden downturn in the share price an investor will still not find it difficult to unload large cap stock. Someone asking are small cap stocks a good investment would be wise to consider liquidity as part of their decision. Looking at past liquidity during downturns is an important aspect of how to find good small cap stocks.
Large cap stocks will frequently issue dividends whereas a small cap stock will rarely do so. This is because small cap stocks will almost always be focused on aggressive growth and thus invest any profits back into the company. An investor can look at historical dividends paid by large cap stocks and with a high degree of certainty predict future payments. This can make large cap shares attractive as income investments over the long term.
The differences between small cap stocks are based on their relative size and typical strategies. As it is impossible to know which cap size the market will favour it is always best to include a mix of different cap sizes in your portfolio based on your individual risk preference and financial goals.
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