You will often hear the term “market cap” when the composition of the equities portion of a portfolio is being worked out. In fact, it is one of the key determinants of investment strategy or “style”.
Market capitalisation is a headline calculation of a company’s worth, based on the total market value of its outstanding shares. Multiplying the number of shares a company has by how much they are selling for tells you whether a stock is small, medium or large cap, but it can also indicate many important things besides – most notably its risk-return profile.
Large-cap companies (those valued at $10bn or more) tend to have dominated well-established sectors for a long time and, while they may not deliver stellar returns because their growth is no longer explosive, they are likely to reward long-term investors with steady gains and very often attractive dividends as well.
Meanwhile, small caps in the $300m to $2bn range are younger, hungrier companies which are very often at the cutting-edge of new sectors and markets. While they are nimble (and exciting), they are more vulnerable to shocks. Higher growth potential comes with higher risk.
In between these extremes are the mid caps, which have a market capitalisation between $2bn and $10bn. As you might expect, these represent a middle path in many ways. They are typically more dynamic than “blue-chips”, but being more established, they can be more resilient than their small-cap counterparts.
Of course, these are generalisations and there is much more to weigh up in individual stock selection. Yet market cap can be a good indicator of whether a company is likely to be heavily exposed to international markets or if it is predominantly domestically focused, for instance.
A robust portfolio is likely to represent a mixture market caps, with proportions varying according to the investment environment of the day. Market cap is only one lens to see equities through, but it can be a very useful shorthand for assessing how much risk – and return potential – they represent.