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Investing in Small-, Mid- and Large-Cap Stocks

Understanding the basics about small-, mid- and large-cap stocks will help you make smarter investment decisions and work towards reaching your financial goals

Alanna Petroff 19 February, 2013 | 1:22PM

This article is part of Morningstar.co.uk's Equity Investing Week.

Not all equity investments are equal. That is certainly the case when it comes to investing in the shares of small, medium and large companies.

The greater the value, the larger the 'cap'

Investing in the shares of small companies (aka small-cap stocks) is very different to investing in the shares of mid-sized companies (aka mid-cap stocks) and large companies (aka large-cap stocks.) For example, in a hypothetical scenario where three companies of varying sizes operate in the same industry and have very similar characteristics, some investors may prefer the smaller company because it has better growth prospects while other investors would prefer the larger company because it has economies of scale and a larger customer base.

Defining Large-, Mid- and Small-Cap Companies

Companies (and their shares) are considered to be large-, mid- or small-cap based on the market capitalisation of a company, which is the overall value of a company. The greater the value, the larger the 'cap'.

Morningstar defines large-cap companies as those that account for the top 70% of the capitalisation of a domestic stock market. Mid-cap stocks represent the next 20% and small-cap stocks represent the balance.

Based on this definition of large-, mid- and small-caps, European and UK companies that are worth more than $9 billion can be considered large-cap companies, as of the end of January 2013. Mid-cap companies are worth between $9 billion to $1.7 billion. Small-cap companies have market capitalisations from $1.7 billion down to $350 million. Anything with a market capitalisation below $350 million is dubbed a micro-cap company, but that is still included within Morningstar’s small-cap category.

Characteristics of Large-Cap Stocks

Large-cap companies are generally the big conglomerates that have recognisable logos, are widely held by investors, and are often featured in news stories. Examples include BP (BP.), Apple (AAPL) and Barclays (BARC).

Investors generally recognise that large-cap companies have a lower potential for aggressive expansion and growth, however, large-cap shares are usually rather stable. These companies are also more likely to pay dividends to investors.

There is a wealth of research and information about large-cap companies. This is useful because it allows investors to be well-informed about these companies, however, this glut of information also means that it is harder to buy these companies at a discount.

Valuations for large-cap companies are generally more fair, making it hard to find a bargain, says Mark Niznik, who manages the Gold-rated Artemis UK Smaller Companies Fund.

“The stock market is much more perfectly priced for equities in big-cap land,” said Niznik.

Characteristics of Mid-Cap Stocks

Some investors prefer mid-cap investments because these companies are known to have better growth prospects and sometimes investors can pick up shares at a discount, since they are not as widely held and popular as large-caps.

“Mid-cap companies typically grow earnings at a faster rate than large-cap companies. Intuitively this feels right; it’s much easier for a company to grow off a smaller base,” says Richard Watts, a portfolio manager at Old Mutual who runs the Silver-rated Old Mutual UK Select Mid Cap Fund. “On our estimates, mid-cap companies have typically grown earnings by 3-4% per annum on average more than large-caps over the last decade. When you compound this up through time it’s a substantial driver of outperformance.”

Mid-cap companies are also frequently the target for mergers and acquisitions (M&A) with larger companies. This can benefit mid-cap investors if the acquiring company is willing to pay a premium for their mid-cap shares.

However, mid-cap investors can be badly burned if they accidentally over-pay for a hot mid-cap company that ends up hitting hard times. Of course, the same could be said for large- and small-cap companies.

Characteristics of Small-Cap Stocks

"Small-cap equities are well known for their higher returns and higher volatility as compared to large-caps and are often used to complement large- and mid-cap exposure in a well-diversified equity portfolio,” explains Morningstar analyst Gordon Rose. “[Small-caps] are often considered to have greater growth potential compared to more mature large-cap firms."

It makes sense that small-caps tend to have higher returns and higher volatility since these are the companies that are generally not as entrenched and well-known within the market, however, they may be experiencing faster growth as they steal customers away from larger competitors. These companies would likely have greater growth prospects, but also a potentially greater chance of failure and setbacks.

“On an individual share basis, it’s a fair comment to say that small-caps are more risky,” says Niznik. “But that’s mitigated by investing in a well-diversified fund or a well-diversified index.”

There is also a better alignment of interests between small-cap investors and the board of a small-cap company, says Niznik.  That’s because the board will own a relatively large stake in their company and they won’t want to ‘go down with the ship.’

“If you look at ownership of small-caps, very often the board has a far higher ownership of that company, and so I argue that the board is far more incentivised to ensure their company performs … You get a lot more passion,” says Niznik.

Small-cap companies also grab fewer headlines and garner less interest and research, allowing investors to “find some gems” for cheap, says Niznik.

Dan Nickols, a portfolio manager who runs the Gold-rated Old Mutual UK Select Smaller Companies Fund also believes it’s easier to find small-cap “gems” at discounted valuations.

“For me, the pre-eminent argument for investing in the UK small-cap space is that it is a relatively inefficient market, where the stock of knowable information about a company is less readily reflected in share prices than is likely to be the case for larger companies. Thus there is greater opportunity to add value through good stock selection than in larger market capitalisation indices, where companies are more intensively analysed and where share prices discount information more efficiently,” wrote Nickols in a Pensions Week article.

The information contained within is for educational and informational purposes ONLY. It is not intended nor should it be considered an invitation or inducement to buy or sell a security or securities noted within nor should it be viewed as a communication intended to persuade or incite you to buy or sell security or securities noted within. Any commentary provided is the opinion of the author and should not be considered a personalised recommendation. The information contained within should not be a person's sole basis for making an investment decision. Please contact your financial professional before making an investment decision.

Securities Mentioned in Article
Security NamePriceChange (%)Morningstar
Rating
Apple Inc104.66 USD1.62
Artemis UK Smaller Companies Acc971.77 GBP0.33
Barclays PLC225.90 GBX1.12
BP PLC438.95 GBX1.08
Old Mutual UK Mid Cap Fund Acc262.92 GBP1.48
Old Mutual UK Smaller Companies Fund Acc289.54 GBP1.07
About Author Alanna Petroff

Alanna Petroff  is a financial journalist with Morningstar UK.