Investing is a great way to build wealth, yet what should you invest in? Not only are there various asset types (e.g. stocks and bonds), but within each asset there are many different categories. When investing in equities (i.e. the stock market), in particular, companies are often divided by size or capitalisation – “cap”, for short.
Some investors lean heavily towards “small caps”; those with a lower overall total share value (capitalisation), but arguably with greater growth potential. Others prefer “large caps” which are perhaps less risky, but might offer lower returns. This picture raises a range of important questions. What are the main differences between small and large caps? Does either one carry a distinct advantage over the other, and how should they feature in an investment portfolio?
Below, our Carlisle-based financial planners at Vesta Wealth offer some answers to these questions. We hope this is helpful to you as you discuss your investment strategy with your financial adviser.
What are small and large caps?
Definitions vary between investment funds and brokerage houses. Generally, a small cap is a publicly-trade stock with an overall share value under $2bn/£1.6bn. A large cap is a stock trading at over $10bn/£8.0bn on a recognised stock exchange.
The latter make up the bulk of the equity markets in the western world. In the US, for instance, large-caps comprise over 90% of the S&P 500, Dow Jones and other marketplaces – including the likes of Apple, Amazon and Microsoft. However, there are dedicated exchanges orientated towards smaller caps.
The UK’s Alternative Investment Market (AIM) is a good example. It lists 821 companies with average market cap per listing at around £80m.
Pros and cons of small caps and large caps
Since large caps make up the bulk of most developed stock markets, they are naturally deemed appropriate “core” investments of many portfolios. They carry the benefit of great transparency, allowing investors to ascertain information easily.
With their large financial bases, large caps are often good dividend payers, although this can vary across markets and sectors. They can also offer more share price stability than smaller stocks. This is because they tend to be more mature businesses with more moderate growth potential; although growth rates and dividend payouts do vary.
However, since large caps issue far more shares than small caps, the former offers less power of ownership for investors. Potential returns are also lower since these companies have mostly moved through their “growth” phase of the lifecycle. The degree to which growth rates fade does vary, and the rating of the shares will generally reflect such characteristics.
Large cap active investors can also have a harder time “beating the market”, since the preponderance of information (which moves very quickly across the world) makes it extremely difficult to find insights that millions of other investors have missed in their analyses. Smaller cap stock are generally less well covered by the analyst community, which can create opportunities for diligent investors.
Small caps, by contrast, offer more growth potential because these businesses are generally earlier in their business lifecycle. If the company has an innovative set of products/services that could disrupt a marketplace then the growth could be incredible. There is also evidence to suggest that small caps tend to outperform large caps over the long term (although the “small cap” effect may be wearing off in more recent years).
However, small caps are also usually riskier investments compared to large caps. Perhaps the company is still to reach consistent profitability. Or, maybe the business model is still to prove itself. Harsh economic conditions (e.g. a recession) could more easily derail a small cap, as liquidity conditions tighten, rendering those less capitalised, vulnerable.
Small cap funds can also be more limited in availability to investors. Managers of many small cap funds will close their doors to new investors once their target for assets under management (AUM) is reached as it becomes more difficult to find worthwhile investment opportunities.
While it is tempting to conclude that all small caps are the same, small caps are not homogenous. Some businesses are solidly profitable and cash generative. While others might be growing revenue rapidly but remain someway off profitability. The latter are more challenging to value.
Implications for investors
At least three considerations need to be weighed by investors who are considering small and/or large caps for the portfolio: strategy, risk tolerance and diversification. These factors will play a big role in how your investments are chosen.
First of all, what is the goal of your portfolio and how will you achieve it? Suppose your primary goal is to generate an income from your investments. Here, you may lean more towards stocks which pay a good dividend (e.g. value large caps). However, if you have a long time to invest and are looking to maximise growth, then small caps may be more appropriate.
Secondly, how much risk are you prepared to take? If you are a more “cautious” investor, then you may prefer large caps with a track record of low volatility. However, if you are happy to see your investments rise and fall a lot during your investment journey (knowing that, over the long term, your portfolio should rise in value), then you may be more comfortable with small caps.
Finally, how diversified are your investments? It is rarely a good idea to hold too much wealth in a single asset class, market or company. Including at least some investments from different market cap categories could be a good way to spread out your risk.
Invitation
If you would like to discuss your financial plan and retirement strategy, then we would love to hear from you. Get in touch with your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.
Reach us via:
t: 01228 210 137
e: [email protected]
This content is for information purposes only. It should not be taken as financial or investment advice. To receive personalised, regulated financial advice regarding your affairs please consult your Financial Planner here at Vesta Wealth in Cumbria, Teesside and across the North of England.