Street Lingo: What Makes a Stock 'Small Cap' or 'Large Cap'?

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The mumbo-jumbo used in the stock market can stop many potential investors in their tracks. So DailyFinance is deciphering the lingo so you make smarter investment decisions.

Today, we'll start with three basic terms that define the investment strategy of many mutual funds: large cap, mid cap and small cap.

"Cap" is short for capitalization and basically describes the size of the company in terms of its stock market value. Market cap is determined by multiplying the number of shares of stock a company has issued by the stock price. That means a company's market cap can fluctuate, but those daily moves don't usually change its place in these three categories.

A Capital Idea

Apple (AAPL), Exxon Mobil (XOM) and General Electric (GE) are three of the biggest companies in the world. Apple, the world's largest company, has a market cap of approximately $570 billion.

Such giant companies make up the large cap sector. Large caps generally have a market value of more than $10 billion -- maybe $15 billion, by some definitions. That means they tend to be well-established companies with strong financial profiles, and many pay regular dividends.

The mid-cap sector is an often-unloved group in the investment world.

But how about well-known names such as Sears (SHLD) and U.S. Steel (X)? Both were once market giants, but they are both valued at about $4 billion. They are now part of the vast middle class of stocks: the mid-cap sector. This is an often-unloved group in the investment world because the companies are not big enough to be leaders in their industries or new enough to be considered small cap.

Small caps are generally valued at less than $4 billion. Many aggressive investors favor this group because these stocks are considered to have greater growth potential, but their stock prices are generally more volatile, so both the reward and the risk can be greater. In addition, they do not have consistent earnings and rarely do they pay dividends.

"Over the long term, small caps have tended to outperform large caps," said Matthew Coffina, editor of the Morningstar StockInvestor newsletter, even though some of the premium has become less prominent over the past decade or so. He also notes that small caps "appear relatively expensive right now."

Using This Information

How do you use market capitalization in making investment decisions? Most individual investors like you and me make our stock market bets by using mutual funds. There are thousands (that's for another day), but many stock funds have a mission to invest primarily in one group or another. Some use that in the name (Vanguard Small Cap Index (VSMAX) for example), but for the most part you have to read a bit of the fund's prospectus to understand its mission.

Very often, when people refer to "the market," they're talking about the Dow Jones industrial average (^DJI) or the Standard & Poor's 500 index (^GPSC) -- both made up of large cap stocks. And most investment advisers think that area should be in everyone's portfolio. Many recommend buying an index fund of large cap stocks and then diversifying with funds from the other groups.

"The larger caps have been around longer. They're financially stronger. They are lower risk," according to Marc Salzinger, publisher of The No-Load Fund Investor newsletter. He says that because people tend to think about the market in terms of large cap benchmarks like the S&P 500, investing in other types of funds raises your risk "of not earning what you expect" based on the year-to-year variations in performance between the stock groups.

While small cap stocks tend to outperform over the long-term, the year-to-year fluctuations for those stocks and mutual funds fluctuate more. The key to long-term investing success, according to Salzinger, is to "invest steadily, not panic and pick something decent."

In the next post of this series, we'll take a look at another way to divvy up your mutual fund investments by style -- growth, value, balanced and core funds.

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Small cap or large cap refers to Market Capitalization - it's not mumbo jumbo. You calculate market capitalization by the number of shares outstanding (or those held by investors) times the market selling price listed on the exchange boards. For example, investors hold a million shares of XYZ corporation and XYZ common shares are trading at $10 on the big board, so XYZ has a market cap of $10 million (10 times 1 million). A more solid indicator is the book value of a corporation.
Say XYZ corporation owes 9 million in debt, so if you liquidate everything owned by XYZ corp you'll have 1 million in cash, so the book value of the shares is only $1 each even though
the shares are trading at $10 Investors can drive the price of a stock up because they think it has a future profit potential.
During the 1980s most corporations were the reverse of this. Their shares traded say at $5 but they book value was $10 a share. In that case, you could make a tender offer and buy all of the shares at say $6 each, sell everything the corporation owned, and put $4 per share profit into your pocket.
Of course there are a few details to this, but this is the basics for those interested.
On paper I'm the wealthiest, not Gates and not Buffett.

July 24 2014 at 9:31 AM Report abuse -1 rate up rate down Reply