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Different investors are attracted to small-cap and large-cap stocks; however, most people do not know the fundamental differences between the two.
Both present unique opportunities for investors depending on their risk appetite and the ever-changing market forces.
Keep reading our Small Cap vs Large Cap breakdown to see if these two assets can add value and further diversification to your portfolio.
What is Market Cap?
A corporation’s market capitalization, or the total value of its shares in the market, determines whether it’s classified as a “small-cap” or “large-cap.” Market cap describes the size of a company, and investors use it to categorize companies.
The rest of the article will explore the differences between small and large-cap corporations and describe how to capitalize on these distinctions.
But first, let’s set the definition straight for both small-cap and large-cap stocks.
What Are Small-Cap Stocks?
A small-cap stock is defined as a corporation whose market capitalization is between $300 million and $2 billion. Small-cap stocks are well-known brands that are still in early growth stages or have already maximized their growth potential.
Large institutional investors tend to shy away from small-cap stocks because they are riskier. They endure large stock price swings, and small-cap stocks traditionally do not have the financial backing to weather economic downturns (recessions or extended bear markets).
Small-Cap Stock Examples:
- Stag Industrial
- Howard Hughes
- Office Depot
- Bed Bath & Beyond
However, there is a time and place for small-cap stocks in your portfolio. They appeal to investors who are willing to take the calculated risk because their growth potential outweighs the apparent risk.
Hedge funds tend to bounce in and out of small-cap stocks because they capitalize on the quick and dynamic rise and fall of the asset’s share price.
Furthermore, savvy hedge funds and investors can purchase a controlling stake in the company and can implement “changes” to the business that they believe will benefit investors.
In other words, make quick changes (examples: lay off employees, create new products, & cut costs) to increase the share price.
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What Are Large-Cap Stocks?
A large-cap stock is defined as a corporation or business whose market cap is $10 billion and greater. Large-cap stocks are established companies that receive media coverage, are backed by institutional investors, and typically, have a “moat” that defends their market position.
But large-cap stocks typically grow at a slower rate than small-cap stocks. While investing in large-cap stocks is traditionally safer, the return on investment (ROI) may not be as high. Moreover, investors are attracted to large-cap stocks because they usually pay a dividend.
For those that do not know, dividends are when a company pays a percentage of the profit to investors who own stock in the company. Dividends are either paid out monthly, quarterly, or annually.
Large-cap Stock Examples:
Additionally, a lot of the major indices (indexes) track large-cap stocks. A well-known example is the Standard and Poor’s 500 (S&P 500). This index tracks 500 of the largest businesses. Large-cap stocks make up 90% of the U.S. Equity Marketplace.
Contrary to popular belief, large-cap stocks are usually cheaper. Why? Large-cap stocks tend to top off during the expansion phase of the business.
Investors looking for risk and a higher return will shy away from deploying their capital because these businesses have reached their “growth” ceiling. Remember, growth is what investors and traders often chase after.
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How to Calculate Market Cap
Get your pen, paper, and calculator out. We are about to do some quick rocket science. Just joking, calculating the market cap is straightforward and easy. Mastering this will allow you to easily differentiate between small-cap and large-cap stocks.
Here is the formula to calculate Market Capitalization.
- Market Cap = Share Price x Shares Outstanding
Calculating Market Cap Example:
Ron Burgundy’s public company Channel 4 News, Inc. (ticker: NEWS) is currently trading in the San Diego Stock Exchange. While Ron is satisfied with the health of the company, he wants to ensure that Channel 4 is bigger than his rival Wes Mantooth’s news company.
Ron’s dog Baxter fetches the pen and paper, and they sit down to calculate NEWS’ market cap. Ron knows that he needs two pieces of information: the share price and their total number of shares outstanding in the market. Ron turns on the television to see Veronica glowing over NEWS’ recent pullback to $50 per share.
He waves his fist at the screen and shouts, “that she-devil,” but keeps listening and learns that Channel 4 has 10,000,000 outstanding shares in the market.
- Market Cap = $50 per share x 10,000,000 shares outstanding
- Market Cap = $500 million
Ron is happy to find that Channel 4 is larger than Wes Mantooth’s company. Also, he realizes that NEWS is a small-cap stock. Indeed, he is kind of a big deal, but there’s room to grow!
Small-Cap vs Large-Cap: The Differences that Matter
Small-cap stocks generally have a higher “beta” than large-cap stocks, which means the share price of small-cap stocks is more volatile.
A reason for this is because small-caps have more room to grow, and this encourages speculation in the markets. Large swings in the price allow more opportunities for investors to make money in a shorter amount of time.
Unfortunately, the volatility of small-cap stocks also means these businesses are more likely to fail than large-cap stocks. Large-cap companies are more established and have access to ‘cheap capital’ from institutions.
Liquidity is another issue with small-caps, given that they have less outstanding shares than large-caps. This often steers institutional investors away from small-caps because they prefer liquidity.
An analyst at Goldman might buy 10,000 shares and sell them a few hours later. He or she has no interest in becoming a majority shareholder! Purchasing this amount of shares in a small-cap may tie up their capital and require undesirable disclosures.
Small-caps generally receive less coverage from the media than large-caps for this very reason. If big banks aren’t taking small caps on a classy date, why do as much market research on them?
Less available information on a company may result in it being inaccurately priced. However, this presents an enticing opportunity for savvy investors looking to capitalize on these market inefficiencies.
However, it is important to note that smaller corporations are traditionally less transparent with their financials, operations, and general business practices.
There are fewer eyes on them, which means they can get away with some unfavorable business tactics. This makes it hard for investors to execute due diligence and research the small-cap asset.
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Characteristics of Large-Cap Stocks
Large-cap stocks are typically more stable than small-caps because they are less likely to fail. They are often backed by institutional traders (think banks and hedge funds) and have access to capital, which allows them to weather the storm during times of economic uncertainty.
Historically, the knock-on large-caps is that “they can only get so much bigger.” If investors believe a stock has reached its ceiling, they may run to other assets that they believe still have room to run.
Large-Cap vs Small-Cap Trade-Offs: Is Lunch Free?
As you can see, the characteristics of small and large-caps are double-edged swords. While small-caps have more room for growth, they’re volatile for the very same reason! And while large caps may have already had their day in the sun, they’re generally stable investments!
Whether it’s a pro or a con ultimately depends on the individual investor. Some may welcome risk with open arms. Some may be retiring next year. This is why these traits should not be considered “good” or “bad.”
Small-Cap Stock Investments to Consider
The Russell 2000 Index (ticker: RUT) tracks the performance of 2000 small-cap stocks in the United States. It has been used as a benchmark since 1984 to compare the performance of individual small-caps to the broader market.
The Russell 2000 is a market-value-weighted index, meaning that a company’s weight in the index increases with its market capitalization, and vice versa.
Additionally, you can choose individual small-caps to invest in, but the amount of information available on the company can vary to great degrees. That is not to say you won’t find winners. For example, Penn National Gaming Inc. (ticker: PENN) is up 176% YTD.
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Large-Cap Stocks Investments to Consider
The S&P 500 Index (ticker: SPY, VOO) tracks the performance of approximately 500 large-cap stocks in the United States. These stocks are more well-known and include the likes of Apple, Microsoft and Amazon.
While most investors employ dollar-cost averaging when investing in the S&P 500, some try to outperform the index by finding faster horses. This can be an exhilarating endeavor, but few can do so.
There are other indexes full of large-caps but differentiate based on the sector or industry. For example, a popular technology ETF “Invesco QQQ Trust Series 1” (ticker: QQQ) has holdings of Apple, Microsoft, Amazon, and Tesla, to name a few.
An investor may choose an industry-specific ETF if they are confident a certain industry is poised for future gains, but unsure which specific large company within the sector to invest in. This is a common investing strategy used to gain exposure while mitigating unnecessary risk.
Russell 2000 vs S&P 500: Battle Between Two Indices
The difference between them is the degree to which they move. The next few paragraphs will explore these variations.
In periods of economic distress, the Russell 2000 kicks into gear.
- 1979-1982: Russell 2000 outpaced the S&P 500 by 76% — Period of high inflation, inconsistent interest rates, and an increase in unemployment.
- 1990-1993: Russell 2000 outperformed the S&P 500 by 48% — Period of economic recession and slow recovery from the Savings and Loan Crisis and the Persian Gulf War.
- 1999-2013: Russell 2000 rose by 114% with respect to S&P 500 — Period included the Dot-Com Bubble, 9/11, the subsequent War on Terror, and the 2008 Global Financial Crisis. Although small-caps got hammered when the 2008 financial crisis reached its peak in the United States.
In periods of economic expansion, the S&P 500 bullies the small-cap index.
- 1983-1990: S&P 500 outperformed the Russell 2000 by 91% — 1980s boom.
- 1994-1999: S&P 500 outperformed the Russell 2000 by 92% — 1990s boom.
- 2013-2020: S&P 500 outperformed the Russell 2000 by 29% from the later stages of the 2010s recovery and into late 2019.
Small-Cap and Large-Cap Stocks Key Takeaways
Investors react to the news they believe will impact a company’s short and/or long-term future. One could argue that investors react more to how other investors react than to the news itself.
Regardless, the following paragraphs suggest why investors trade small and large-caps differently depending on periods of economic distress or expansion.
#1. Small-caps tend to outpace large caps when the Federal Reserve cuts interest rates.
This is because small-caps are more domestically driven than large-cap multinationals. While large-caps can access fixed-rate debt financing through capital markets, smaller corporations often receive financing through adjustable-rate bank loans.
This makes them more susceptible to good and bad news from the Fed.
#2. Small-caps are less impacted by geopolitical news than large-cap stocks.
As discussed earlier, this is because small-cap stocks are more domestically focused on the economic health of the United States.
While breaking news in China may indirectly affect the publicly traded American hot dog company Nathan’s Famous (ticker: NATH), it would be to a much less degree than it would McDonald’s, who has more than 3,000 restaurants in China.
#3. Historically, small-caps outperform the market in the early days of a bull market.
This is because bull markets often follow massive economic stimuli injected into smaller companies. During an economic recovery, unemployment rates plummet, and small businesses begin to rise from the shadows.
The volatility of smaller corporations reacts to the increasing optimism faster than their large-cap counterparts.
Bottom Line: Small-Cap vs Large-Cap Stocks
As you can see, size does matter in the investing space, but one size is not necessarily better than the other.
What is important is knowing how various cycles in the market affect them differently, and how to position yourself to gain from these disparities.
Now it’s time to put your knowledge to work. Get started here (button) to invest!