In the investing field, the frequent question whether to invest in small or large caps is highly popular among the investors.
In fact when the volatility increases in markets ,it becomes all the more tough to decide which strategy to use for small cap vs large cap investing.
As the allocation of the stocks in the category like small cap, mid cap or large cap within the portfolio is very much important. Even some investors start thinking to exit from all the stocks and try to go for mutual funds or debt in case of bear market.
I am sure at some time or other, you must have also faced the same problem. I will try to device a mechanism to finalise the strategy to invest and try to de-clutter your investing mind.
Before understanding the investing in companies of different market capitalization, we have to understand the categorization
What is market capitalization?
Market capitalization is the total valuation of the company based on its current stock price and the total number of outstanding stocks in the market. Market capitalization can directly be calculated by multiplying the current price of the company’s share in stock market with the total outstanding shares of the company.
It will be easier for you to understand the market capitalization by one example:
Suppose, a company has 20 crore outstanding shares and the present market price of each share is Rs100. So the market capitalization of this company will be 20 crore x 100=Rs 2000 crore.
Classifications of companies in Small Cap, Mid Cap and large cap
As per the category of market capitalization Stocks of companies are of three types.
Companies having market cap of Rs 20,000 crore or more are considered as Large-cap companies . Mid-cap companies have market cap between Rs 20,000 crore to Rs 5000 Crore. Small-cap companies have a market cap of below Rs 5,000 crore .
Other criteria by MF schemes as per AMFINDIA are as per the ranking of total available companies in market.
SEBI circular categorised large cap, mid cap and small cap companies to ensure as uniformity for investment universe for equity mutual fund schemes.
Large cap Vs small cap companies :
Matching growth and risk together
Investor determines the returns and the risk together before investing in any share. This approach also helps the investors to choose the stock that can meet their risk and diversification criterion.
Benefits of investing in large cap
Investors consider the low risk level in large caps as compared to small and medium cap stocks because they are leaders in their sector .These large cap companies already have their proven records with high market share. For example big giants like : Reliance Industries, TCS, Infosys etc
Potential Returns & Dividend
The stock prices are stable (fluctuation in a small range) and dividend policies are also well known. These are market leaders & well reputed in the market. An investor usually invests in large cap companies to make passive, regular income in the form of dividends or steady appreciation in the share price. You can get growth rate of a large company between 8-10 %. And same CAGR in share price.
The large cap stocks are stable in market because these are companies who have great management and maintained a good reputation in the market and financial stability.
Benefits of investing in small-cap funds
Higher growth rate
Small-cap stocks achieve higher growth rate in comparison to large bench mark like NIFTY-50 and provide high returns for long time. The growth is higher and all mid or large caps were small caps few years ago. Small cap index outperformed the NIFTY-50 in long term by huge margins
They are risky as they may face illiquidity (short of buyers-sellers) in the market. They also have a risk of closing down of company or engaging in frauds .The price of these small caps can be manipulated as the size of business is very small.
Lesser researched and undervalued
As these small caps are lesser researched and are not on the RADAR of institutional investors and mutual fund managers. ,they are some times have cheap valuations. These can be purchased on bargain prices and held for long time monitoring the growth.
Demerits of investing in small caps
These small caps don’t pay dividends as they re invest their profits in the business itself for further expansion and growing the business.
Small caps have small float of shares in the market. Hence these are traded lesser in volumes and takes longer time to finalize the trade. Lack of liquidity remains a challenge for small cap stocks as investors can purchase a limited quantity of shares
Risk of complete capital loss
Most of the small cap companies die out before they become mid or large cap companies. Only 2-5 % small cap companies survive for long terms .So the investors diversify their portfolio to mitigate the risk.
Action Plan: Key Takeaways
In a nut shell, investors should not consider stock on the basis of the market size, but on the basis of their ability to generate further returns and growth potential. The valuation should be the central idea behind investment to get handsome returns in future.
That means market cap of the company does not indicate the risk in the stock but rather it is the business of the company. If the business of the company does not perform well ,then risk comes in the stock irrespective of large cap or small cap .
As per my experience, you may make a ratio of % of small, mid and large caps as per your risk appetite .The same ratio can be backed up with one’s age and financial goals. Suppose if your age is 30 years, then out of the savings/ investment surplus, you can invest 50% in mid cap, 30% in large cap and 20% in small cap.
If you are :let us say of 40 years, you may plan for investing 50% in large cap, 30 -35% in midcap, 15-20 % in small caps. The same plan may be tweaked as per your financial situation.
It is understood from the above explanation that smaller cap stocks are riskier which means they are prone to larger losses in the short-term, but can also move up fast as per market conditions and economy.
However for a very long terms and achieving more returns, you may use a basket of small cap stocks for 10–15 years or more years. To minimize the risk , it really is important to have a mix of large cap, mid cap, small cap and international stocks that are well diversified in various industries for any long term financial goals.