When investors talk about "market caps," they’re simply discussing how big a company is.
“Market capitalization” is the total value of all the shares of a publicly traded company. Mathematically, it’s the number of shares multiplied by the price per share.
Since share prices change throughout the day, the market cap of the underlying company also fluctuates. However, for most companies market cap tends to stay relatively consistent in the short term.
For example, a big company like Apple (AAPL) is considered a large-cap stock (actually a mega-cap stock, which we’ll explain in a moment).
As of today (10/24/18), Apple has 4,829,926,000 shares outstanding on the public markets.
Their stock price closed today at $215.09.
If you multiply those two numbers together, you arrive at a market capitalization of $1.04 trillion. They’re currently the largest company in the U.S. stock market.
A small cap stock is a small company, such as GoPro (GPRO). As of today (10/24/18), their market cap is only $894 million.
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Here are the official categorizations for companies based on their size:
Now, most people simply call big companies “large-cap stocks,” mid-size companies “mid-cap stocks”, and small companies “small-cap stocks.” People typically don’t get as specific as “nano-cap” or “mega-cap.”
So, now that we know the different size bands, how many stocks fall into each category?
As of 10/30/18, there are nearly 8,700 stocks trading in the U.S. Here are the number of stocks that fall into each market cap group:
What’s amazing is that nearly 75% of all the stocks on the U.S. market are small-cap stocks, micro-cap stocks, or nano-cap stocks.
The large-cap stocks and mega-cap stocks that investors talk so much about are just the tip of the iceberg, making up only 11% of the total.
This illustrates an important point:
Most investors focus on large stocks, which leaves an ocean of untapped opportunity in the small stock space.
No matter how you cut the data, there's a clear trend:
Small stocks have historically outperformed large stocks.
Let’s look first at this chart from Perritt Capital which tracks $1 invested into micro-cap, small-cap, mid-cap, and large-cap stocks from 1926 - 2017:
We see that micro-cap stocks return the best, turning $1 into an astounding $36,929 over a period of 92 years. Small-cap stocks aren’t far behind, growing to $23,522.
They also look at returns a different way: During that 92-year period, how did each stock size perform during an average 20-year chunk of time?
We see that micro-cap stocks returned the best 20-year run (far left bars, "Maximum Value"), delivering 24.09% per year.
Micro-caps also had the least painful 20-year stall out (middle bars, "Minimum Value"), delivering 6.05% per year.
And on average, micro-caps had the best overall 20-year performance (far right bars, "Average Annual"), delivering 13.76% per year.
Again, we see this trend: The smaller the stock, the better the returns.
But 1926 - 2017 is a pretty broad timeline. How have small stocks performed more recently?
Morningstar provides a look at small stocks vs. large stocks (and other assets) for the last 1, 3, 5, and 10 year periods (through 2017).
In the short term (3-5 years), performance is mixed, with both small and large U.S. stocks beating out bonds, international stocks, and emerging-market stocks.
But once we zoom out and look at the last 10-years, the same trend emerges again: Small stocks edge out large stocks.
Let’s dig into this trend by breaking companies into groups by size.
An analysis by Duff & Phelps divides all stocks into 10 even groups (which they call “deciles”) based on their size.
“Decile 1” is made up of the largest stocks on the market, while “Decile 10” is made up of the smallest stocks.
There are two important things to learn here:
First, as we saw above, the smaller the stocks, the higher the returns. To see average annual compound returns, look at the first column, “Geometric Mean.”
But there’s a second important point we can learn from this graph: Higher returns from small stocks come at a price - greater volatility.
If you look at the standard deviation column, you’ll see the numbers move dramatically higher as the stocks get smaller.
What does this mean?
Standard deviation measures how much the annual returns of each decile of stocks vary from their average over time.
For example, the large stocks in Decile 1 have a low standard deviation which means their returns tend to not stray too much from their average. In other words, they’re relatively steady over time.
But looking at the smallest stocks in Decile 10 we can see their standard deviation is very high which means their returns tend to stray a lot from their average. In other words, they’re all over the place.
Now, that’s not necessarily a bad thing. Those erratic returns could tend towards the upside. But it speaks to the volatility and unpredictability of small stocks vs. large stocks.
Similar to our recent lesson on stocks vs. bonds, some investors choose the inferior returns of bonds because they’re a lower-risk investment.
A similar argument could be made for large stocks vs. small stocks. Some investors will choose lower-returning large stocks because they’re more stable and less erratic (among other reasons).
There are a few reasons why small stocks have historically outperformed large stocks.
This list covers some of the main points, but there are more concepts we’ll discuss in a future lesson (Lesson 23: A Step-by-Step Guide to Picking the Best Small Cap Stocks):
Let’s look at a series of charts comparing small vs. large stocks from Perritt Capital.
First, small stocks are not well covered by analysts.
We can see that the smaller the company, the less analyst coverage.
Why does that matter?
Analysts work for financial institutions researching stocks and publishing their findings.
It’s easier for an average investor to profit from an undiscovered stock opportunity when analysts haven’t published research on it.
For example, let’s say you work in the mining industry and you learn of a small company that’s providing incredible new equipment for your industry. Now, this isn't any kind of insider information, it's just something only folks intimately familiar with mining would understand.
Because of your experience, it may be clear to you that this company will continue to grow fast based on their superior products. So you buy their stock. A month later they report blowout earnings and the stock soars 30%.
If analysts had been publishing detailed research trumpeting this company’s incredible products, more investors would’ve bought the stock and the price would’ve been bid up already when you went to buy.
And their strong earnings results wouldn’t have been such a big surprise because analysts usually forecast their own estimates for upcoming earnings reports.
Put simply, while large stocks like Apple have very few secrets, small stocks can hold many.
Mergers and acquisitions (M&A) can be an incredible driver of individual stocks returns.
In order to earn shareholder approval for a proposed acquisition, the purchasing company must often pay well above the current market price for the company they’re buying.
This leads to an instant spike in the target's stock price when the acquisition is announced.
Because of their size, small stocks are easy targets for large companies to acquire and integrate.
We can see that over the last 25 years, small-cap and micro-cap stocks have made up 68% of all M&A. During the same period, large-cap stocks made up just 4.6% of all M&A.
While M&A isn’t the main driver of outperformance for small stocks, it certainly helps to have a stock pop 20%, 30%, 40%, or more in a single day on news of an acquisition.
Another reason for strong small stock performance is that employees have more at stake.
Insider ownership measures what percent of a company’s stock is held by its own employees.
At large companies, we can see insider employees own a relatively small share of the company. But for small stocks, between 17% - 22% of the shares of these companies are owned by their employees.
Why does this matter?
When employees (especially high-ranking executives) own a lot of their own company stock, they’re more motivated to make sure the stock performs well. Since small stocks have so many insider owners, their executives are working extra hard to deliver top performance.
Finally, there’s one more very big reason why small stocks can outperform their peers.
Proven investing strategies - such as those based on buying stocks that offer strong valuation, momentum, financial strength, or earnings quality - perform dramatically better on small stocks than on large stocks.
We can see this in action using this chart from O’Shaughnessy Asset Management.
It shows how much “alpha” (just think of alpha as market-beating power) there was from 1970 - 2015 for several different investing strategies that were applied to large stocks, small stocks, and micro stocks.
In every case, the value, momentum, financial strength, and earnings quality strategies performed dramatically better among small stocks and micro stocks than among large stocks.
For example, over the last 45 years buying the most undervalued micro stocks was twice as profitable as buying the most undervalued large stocks.
This insight will have enormous implications when we get into the best investing strategies later in this course.
While small stocks have clearly outperformed large stocks over the long term, that doesn’t mean investors should only invest in small stocks. And it definitely doesn’t mean that small stocks will automatically be a good investment.
Small stocks often come with their own unique risks, such as high volatility, low information availability, and greater vulnerability.
Smart investors diversify appropriately based on their investing goals and try to find the best stocks among various sizes.
While small stocks offer investors a great opportunity to earn market-beating returns, they also offer a higher risk of getting burned.
For example, Amazon (AMZN) is very unlikely to go bankrupt in the next five years. The same could not be said for some small stocks.
And in any given year, the best large stocks will almost certainly outperform the worst small stocks by a very wide margin.
We believe smart investors can make great profits with any size stock, so long as they have a good investing strategy.
We defined various different stock sizes ranging from nano-cap stocks up to mega-cap stocks and provided a count of how many there are of each size.
We also learned some key lessons about market caps:
Next up, let's break down how stocks are sorted into different sectors and industries, and discuss what that means for your investing strategy: Lesson 7: Sectors & Industries: How Stocks Are Grouped by Business Type
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