Terms such as large caps, small caps, micro caps are often heard and used by professionals on the Street. These terms/labels refer to a company’s market capitalization (or ‘cap’ for short). The distinction between small, medium and large capitalization companies has changed over the years. What used to be a large cap some 30 years ago, today could be a medium, or even a small cap. Note that calculating a company’s market capitalization is easy: what needs to be multiplied is the number of outstanding shares by the stock’s market price.
Industry experts will often say that small caps are much better investments in the long term because they have plenty of room to grow into a large cap.
So, in a very broad meaning, market capitalization is the market’s “evaluation” of a company. You can have a large cap company, such as General Motors, for example, and peg it as less risky because the market values it as a large cap. However, considering how credit rating services perceive General Motors as of late, (rating the company right down to the junk level), that “less risky” label may have to be rethought.
Granted, with large caps, (also often referred to as blue chips), there is less implied risk then with small caps. The bigger a company means the more resources might be available to cushion whatever the market throws at it. Unfortunately, when things go terribly wrong with a large cap company, as was the case with Enron, for example, the larger it is, the harder it falls.
Business media mostly report news and commentaries on large caps because large caps generate most of Wall Street’s investment banking business. So what is a small company to do?
One of the ways to increase investor awareness is to hire an investor relations firm. A good PR firm will promote the company, and make sure small investors know about its technologies, products, business models, etc.
Investors also like small caps particularly because they are flying under Wall Street’s radar. When institutional investors get involved, they tend to buy shares in big blocks. They also generally care little about a quarter here or a dime there. And, buying big blocks of shares will eventually drive the price of a stock up.
With small caps, in contrast, daily trading volumes are low, which often keeps their market prices low as well. Simply, the buying pressures, or selling pressures for that matter, are not nearly as strong in case of small caps as they are with large caps. But without that pressure, prices of small caps are much more affordable, leaving individual investors with much more maneuvering space.
It is often said that large caps have little room for growth and the possibility of a value play in that arena can be relatively limited. This is why ordinary investors should make room for small cap companies in their portfolios. First and foremost, the potential for high returns is certainly there because small caps have considerable growth potential. However, the investors should remember that the smaller the cap, the larger the risk. This means that investors should allocate asset classes in their portfolios according to their respective investment objectives and risk tolerance.