Small-Cap vs. Large-Cap Stocks: Key Differences
While the world's largest companies receive much of the market's attention, smaller companies have historically played a significant role in the investment world and long-term wealth creation.
Small-cap and large-cap stocks exhibit different behaviors during varying economic cycles. They are also affected differently by interest rates and other economic indicators. Understanding the differences between the two stocks can aid investors in forming diversified portfolios that best suit their financial situation.
What Are Market Capitalizations?
Market capitalization or market cap indicates the total value of a company's outstanding shares. It is calculated by multiplying the company's share price by the number of shares that are currently outstanding.
Based on their market cap, companies are generally categorized into four groups:
Large-cap companies
Mid-cap companies
Small-cap companies
Micro-cap companies
Characteristics of Large-Cap Stocks
Large-cap stocks belong to companies that are well established in the industry.
Some of the benefits that they offer include:
Strong brand recognition
Global operations
Diversified revenue streams
High levels of stability and cash flow
Easier access to financing
Many of these companies have weathered economic cycles throughout the years, attracting numerous investors looking to own stocks that offer stability.
Another benefit that large-cap stocks offer is the potential for the company to pay dividends to its shareholders.
Characteristics of Small-Cap Stocks
Small-cap stocks belong to companies that are still growing.
Small-cap stocks offer investors:
The potential for high growth in revenue
Greater industry flexibility
Exposure to newer and growing industries
Opportunities to acquire other companies
The downside of small-cap stocks is their volatility. Because there are limited financial resources and a shorter history of the companies involved, there is a higher chance for their share price to experience significant swings.
To account for the increased risk of small-cap stocks, investors can expect a higher potential return on their investments.
Economic Conditions Affect Performance
The size of a company can impact how well it performs in the economy under specific conditions.
Large-cap companies tend to outperform under conditions such as high uncertainty, high interest rates, economic instability, and high costs of acquiring capital.
Small-cap companies perform better in periods of economic growth, higher demand for goods and services, increased access to capital, and higher business investment in the economy.
The economic conditions that exist in a country or market can significantly impact investors’ stock selections.
Liquidity Differs Between Market Caps
There are notable differences between the liquidity of stocks with varying market capitalizations.
Large-cap stocks tend to have higher trading volumes, narrower spreads between the buying and selling prices, and higher levels of ownership by other investors such as mutual funds.
Small-cap stocks usually have lower trading volumes, higher spreads between buying and selling prices, and larger price differences between the two.
The differences in the liquidity of stocks should inform an investor’s decision on where to allocate their money.
Valuation Opportunities
Smaller companies tend to receive less attention from analysts and other institutional investors.
This can present opportunities to invest in companies that may be undervalued due to the lack of attention from other investors.
The drawback to small-cap stocks is that they will experience the same risks as other stocks.
Large-cap stocks are researched and followed closely by numerous professional investors.
While the information available on these stocks may be more transparent for other investors, it also means that there are fewer inefficiencies in the pricing of these stocks.
Diversification Benefits
Investors can diversify their investments by including companies of different sizes within their portfolio.
A diversified portfolio could contain stocks from different industry and regional lines and of varying small-, mid-, and large-cap companies.
Portfolio managers often invest in companies of different market capitalizations to reduce the risk to their portfolio and maximize their returns.
Risks to Consider
Small- and large-cap stocks come with specific risks.
The risks of investing in large-cap stocks may include limited opportunities for growth due to the maturity of their products and services and their well-established markets.
The risks of small-cap stocks include the volatility of their share prices, limited financial resources, higher financing costs, and higher risks for the company to experience poor business performance.
These risks apply to both types of stocks, but investors should always consider the company’s financial and operational fundamentals before investing.
Strong businesses exist in every market segment for stocks.
Building a Balanced Portfolio
Most experienced investors avoid stocks of a specific market-capitalization range.
They form investment portfolios that consist of large-cap, mid-cap, small-cap, and international stocks.
The portfolios are reviewed periodically to ensure that the stocks have a balanced representation in their portfolio.
Balancing the potential for growth with the stability of a company’s shares is the goal of most investors over a sustained period.
Key Takeaways
Market capitalization determines the total value of a public company.
Large-cap stocks are more stable and liquid than small-cap stocks.
Small-cap stocks offer more potential growth but also exhibit greater volatility.
The economy influences the performance and growth of stocks with varying market capitalizations.
Diversifying investments among company sizes can help improve the resilience of an investor’s portfolio over time.
Always consider a company’s business and financial fundamentals when investing rather than the company’s size.
Conclusion
Small-cap and large-cap stocks have distinct roles to play within a diversified investment portfolio. Large-cap stocks offer investors the stability and returns that they require over time. Small-cap stocks, on the other hand, offer higher growth potential for investors who are willing to take on the additional risks involved. By understanding the influence of market capitalization on stocks, investors can design their portfolios appropriately to weather the rough economic times and enjoy higher returns over the long term.