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What are “small caps” and “large caps” when investing? Are there advantages to investing in one, versus the other? As financial planners, our role is to help people understand how these types of assets work and how they might feature in an investment strategy. Below, we explain the differences and how they can be used to diversify a portfolio. We hope you find this useful and invite you to contact us if you’d like to discuss your own investment strategy.
What are small & large caps?
The word “cap” is shorthand for “capitalisation”, and refers to the size – or value – of a particular company that can be invested in. So, the more a company is worth, the bigger the capitalisation. Once a company reaches a certain valuation, it becomes classed as a “large cap”. Most other companies will be designated as “small caps” – even if they are worth millions of pounds/dollars.
Generally speaking a large (“big”) cap is defined as a company worth $10bn or more. A small cap is a company worth between $300 million and $2 billion. Whilst there are no strict rules for identifying a company as a mid-cap, the name refers to one that has market capitalisation that is too small for it to be a blue chip (or large cap), but which is bigger than a small cap. In the UK companies in the FTSE 250 index are considered mid-cap, sitting in the $2 billion to $10 billion space. The way the value is typically calculated is to take the total number of outstanding shares (usually declared on the company’s balance sheet) and multiply this number by the current share price. For instance, if the share price is $100 and the company has 1m shares outstanding, then the market capitalisation (market cap) is $100m.
Advantages and disadvantages
Large and small caps are not limited to specific markets, industries or sectors. After all, different sized companies exist in many areas of the economy. This means that investing in both can be a powerful diversification strategy – spreading your risk across many different companies, so you are not overly-exposed to volatility or failure in any particular company. Including both within a portfolio also allows you access their respective, overall strengths.
Large caps, for instance, are typically regarded as “safer”, more stable investments due to the longevity and financial clout underpinning large businesses. Small caps, however, are often still in the “growth phase” of their business lifecycle – opening up the potential for higher returns.
However, large and small caps do have their respective weaknesses which investors need to be wary of. In particular, the former can represent limited investment growth opportunity since their marketplaces are already dominated by the company and its competitors. Large caps can also be more resistant to necessary change. For instance, large oil companies may struggle to move into a more “eco-friendly” business model compared to a younger, smaller company which can adapt more easily.
Small caps are often regarded as “riskier” investments compared to large caps. They are more sensitive to interest rate rises, since they cannot absorb the higher cost of borrowing as easily as a large business (with more assets/cash reserves). Small caps may also suffer from a lack of business and market experience, and their business model (products, services etc.) might not yet be “proven”. Smaller companies could be derailed more easily by an expensive lawsuit brought against them, and their financial instability can be higher – especially during the “startup years” when businesses often do not make a profit.
Implications for investors
Given these respective pros and cons for both types of company, it is important to include them only after establishing your investment goals, strategy and “risk tolerance” with your financial planner. We see this difference as further evidence that ‘risk’ and ‘return’ are related. For instance, if you are happy to bear more volatility in your portfolio and have a long time horizon in front of you, then you may be prepared to include more “high risk; high growth potential” small caps in your mix of investments. If, however, you are in/nearing retirement and wish to preserve your wealth whilst drawing an income, then you may lean more towards large caps which pay a good dividend.
Invitation
Interested in finding out how we can optimise your financial plan and investment strategy? Get in touch today to arrange a free, no-commitment consultation with a member of our team here at WMM.
You can call us on 01869 331469
