Of the entire universe of investable stocks, companies are divided into subgroups based on their market capitalization (or simply market cap). Market capitalization is a measure of the size and value of a company. It’s calculated by multiplying the company’s total number of shares outstanding by the price of one share.
Based on this value, the companies are then classified into 3 subgroups: large caps, mid caps, and small caps.
Large caps are companies with market capitalization value that exceeds $10 billion. Within large caps is another subcategory of companies known as the Blue Chips.
The name comes from poker, where the blue-chip usually has the highest value. A blue-chip stock in a company has an established history of financial strength, stability, and profitability. Blue-chip stocks are high-quality investments and are often priced quite high due to their reliability in bull and bear markets. The famous Dow Jones Industrial Average is an index that tracks 30 blue chip stocks. Although there are no specific requirements to be classified as a blue chip, these companies tend to be leaders in their industry and well known large cap stocks.
Investing in large caps or blue chips generally yields the least amount of risk when compared to mid and small cap stocks. They have accumulated large amounts of assets to help them weather economic downturns. These companies generate consistent earnings and also generally have lower betas than mid and small caps. Because of lower risk, large caps have historically offered lower returns than mid and small cap stocks. Large caps also have less growth potential than mid and small caps. Also, because everyone sees these stocks as low-risk investment opportunities, their prices are generally higher than mid and small caps due to high demand.
They can also act to shield portfolios from huge losses during bear markets. Large caps are often valuable to income investors since these companies also provide stable dividend income. (Revisit the chapter on 'Choosing Your Investment Style' to refresh your memory on the different types of investors.)
'Mid Caps' are companies with market capitalization values between $2 billion and $10 billion.
Mid caps, as their name indicates, are companies not quite large enough to be large cap and not small enough to be small cap. As such, they are medium risk investments that generate medium returns. They have betas - a measure of the volatility, or systematic risk, of a stock or a portfolio in comparison to the market as a whole - that are generally higher than large caps, but lower than small caps. Mid caps are generally older than small caps, but they still hold growth potential with the possibility of becoming a large cap. Mid caps are often leading indicators of a bull market. High returns from mid caps can indicate a potential bull market in the near horizon.
Because they are less risky than small caps but generate a higher return than large caps, they can prove very important to investors. A well-diversified portfolio should have a handful of well picked mid caps with good growth potential and solid fundamentals.
'Small Caps' are generally companies with market capitalization values from $250 million to $2 billion.
Historically, small caps’ average returns have outperformed large caps. Small caps are usually new and small companies that have high earnings growth potential. Furthermore, because small caps are less followed by investors and analysts, their demand is lower than larger companies. As a result, these companies are often undervalued. Thus, many small caps are potential value and growth stocks. However, greater return also comes with greater risk. Because these companies are young and small, they are much more vulnerable to economic downturns. They have limited assets on their balance sheet to protect them against hard times and are more likely to go bankrupt.
A well-diversified portfolio should not be full of small caps. Instead, investors should carefully pick a few small caps with high earnings growth rate, sound management, and great future prospects. On average, small caps have higher betas (more on this later) than mid and large caps, and investors need to fully understand the risks before investing in small caps.