Similarly to sector rotations, the timing of when to buy and sell small and mid-cap stocks can maximise an investor’s portfolio. The size of a company has a huge impact on the characteristics of the stock. Knowing the difference between these types of companies will assist the investor to select the stock which is the most suitable for their needs. Understanding how different market caps react to market sentiment will help the investor protect capital and increase returns.
Large Caps
Characteristics:
A large cap stock is classified as a company which has a market capitalisation of more than $10 billion. Large cap or blue-chip stocks are the largest companies on the Australian stock exchange. These companies have generally been around for a long time and are considered stable companies. They usually offer a dividend as their businesses are well established and have consistent cash flows.
Advantages and Disadvantages:
These are stable companies, so they usually offer dividends because of their strong earnings. They are considered less risky and have high liquidity in the stock market. They have less volatility in their stock price. These companies are mature businesses so these stocks do not experience as much capital growth as small caps. Hence investors will, on average, not see as much stock price appreciation as small cap stocks.
Who is suitable:
Investors who are looking for income to fund their living costs who are no longer working will find large cap stocks suitable as they usually pay a dividend. Risk adverse investors may also find large caps appealing as they have lower risk than mid and small caps but they don’t generate as much capital return.
Best time to buy:
Large caps are more popular in bear markets as investors look for safe and stable investments. Investors will see that large caps will be the fastest to recover after a sell off. One of reasons is that they have been the least impacted during a sell off. During volatile times, when there is uncertainty, investors will look to safer investments such as large caps. As these companies have been around for longer periods, they have more cash reserves during fragile economic times so investors feel more confident investing in these stocks.
Mid-Caps:
Characteristics:
Mid-cap stocks have a market cap ranging from $2 billion to $10 billion. These stocks are expected to generate rapid growth. Investing in mid-cap stocks means you are investing in established businesses that have usually not been around as long as large cap companies.
Advantages/Disadvantages:
These companies offer a hybrid of growth and stability. They can offer more capital upside than large cap stocks but are considered less risky than small cap stocks. Mid cap firms historically grow their earnings faster than small and large cap firms. As these businesses are established, investors will see less capital appreciation in these stocks compared to small caps. These firms are not as stable as large cap firms as they do not have as much capital.
Who is suitable:
For the investor who is looking for a capital gain with less risk than a small cap, then a mid cap stock selection would be most appropriate. There are mid cap stocks which also pay dividends. Mid cap stocks are generally profitable as their earnings tend to grow at a faster rate than the average small cap.
Best time to buy:
Mid cap companies do well in the expansion phase of the business cycle. This is when interest rates are still cheap. Mid caps perform better than large caps when the economy is revitalizing.
Small Caps
Characteristics:
Small cap stocks are usually companies that are younger. They are generally looking to grow their businesses at an accelerated rate. Small cap companies have a market cap between $300 million and $2 billion and are often categorised as growth stocks.
Advantages/Disadvantages:
These are business in the growth phase so there is higher potential for capital growth. Small cap companies usually domestically focused so they are less affected by conflicts in international trade. These firms are not as stable as large cap firms as they do not have as much cash. As these businesses are in the growth phase, they may reinvest funds from earnings and not pay dividends to investors. There is also less liquidity in the stock market for small caps. Share prices of small cap stocks experience high volatility. This could lead to stock prices falling harder in bear markets. There is more risk in investing in small caps as companies are newer and are less established businesses. Small cap stocks are also reliant on external capital as their capital is limited.
Who is suitable:
Investors who are looking for capital growth who can take on risk would find small caps suitable. These investors may not need income immediately so can sacrifice income for capital growth. They also have a long investing time horizon to ride out the stock price fluctuations.
Best time to buy:
Small caps rise faster than large caps in bull markets. However small caps fall harder than large caps in bear markets. In market sell offs, small caps are the first to go as investors see these as riskier. Investors will see a lack of liquidity in small caps stock when there is a sell off. There will be a lot of sellers and not a lot of buyers which will drive the price down further. During recessionary periods, these are out of favour with investors and may go through a period of underperformance compared to larger cap stocks. When the economy is strong and there are higher levels of consumer confidence, small caps do well as people spend money with less constraints.
Lauren Hua is a private client adviser at Fairmont Equities.
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