Our most recent blog introduced the topic of investment style, looking specifically at why many are now advocating a switch in focus from growth to value i.e. the hunt for undervalued stocks. We now turn to another not-to-be-forgotten element of investment style: market capitalisation. Again, this is timely to discuss since new research is turning old assumptions on their head.
First of all, what do we mean by “market cap”? In short, a company’s market capitalisation is one measure of its worth, calculated on the basis of the total market value of its outstanding shares (how many shares it has multiplied by how much they are selling for). This figure tells you how big a company is and whether it falls into the small-, mid- or large-cap range.
The reason this is important is that market cap can tell us a lot about the risk-return profile of a particular company and other features that will help determine what – if any – place it warrants in a portfolio. Market cap considerations can also drive investment strategy, or style, in a far broader way.
Defining small, medium and large
Small-cap companies (those with a market cap of $300 million to $2 billion) are very often young organisations operating in nascent areas which may well turn out to be high growth. The downside to their agility and profit potential is of course that they are more vulnerable and present higher risks. In investing, there is seldom a free lunch.
At the other end of the scale are large caps ($10 billion or more). These are often household names which have dominated well-established sectors for a long time. While large caps are unlikely to deliver stellar returns for the short-term investor, they will reward the patient over the longer term with steady growth and in all likelihood attractive dividend payments – which small caps may not be in a position to pay at all.
In the middle – and the topic of much discussion today – are mid caps, companies with a market cap between $2 billion and $10 billion. As you might expect, mid caps represent a happy medium in many ways, particularly on risk. While they tend to be more dynamic than their large-cap counterparts, they also tend to be well established, meaning they also have the strength to withstand downturns that their small-cap cousins so often lack.
Alongside value versus growth, market cap is a particularly important consideration today because of the investment environment we find ourselves in. And, as previously mentioned, conventional wisdom is now being called into question.
It is generally thought that large caps provide a safe haven when major events (like global pandemics) cause market downturns, which is why they are often known as “defensive” stocks. Then, as recovery takes hold, small caps come into their own, taking advantage of their nimbleness and ingenuity to serve as the engine room of growth. So far, so logical.
However, according to new research, these assumptions may not be so certain, and could in fact be entirely wrong.
Might the middle road be best?
State Street Global Advisors recently examined four “systemic risk periods”, COVID-19 being the latest, then going back to the Global Financial Crisis, the bursting of the “Dot-com bubble” around the millennium and the Asian currency/Russian Financial Crisis of 1997-2000. Its findings are surprising, to say the least.
According to this analysis, large caps did not decline the least as markets tanked; nor did small caps lead the recovery. In fact, mid caps fared the best during both stages. What is more, mid caps generally suffered smaller drawdowns and recovered a lot faster too.
State Street therefore advises that investors be sceptical of the conventional wisdom that might push investors to find safety in large caps in the dark days of crises and to pivot to small caps when green shoots begin to emerge. For an efficient balance of both downside risk protection and upside potential, it seems there is a powerful rationale that mid caps are where the smart money should go.
The takeaway here is that just because a notion has been held to be true for many years, doesn’t necessarily make it so – and that sometimes the middle road between two extremes is best. As with so much in portfolio management, balance is the key.