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If you’re investing in shares or mutual funds, your returns depend a lot on whether you choose large, mid or small cap stocks for your portfolio. In 2023, large-cap equity funds gained about 25%, while mid-cap funds gained 40% and small-cap funds delivered 45%. So why not just buy small-caps and avoid everything else? It doesn’t work like that! In this episode of Question of Money, I’ll be explaining what market-cap means and why you can’t stick just to small-caps.
What’s market cap?
First up, let’s understand what market-cap is. As a follower of Question of Money, I’m sure you know that an equity share represents part ownership of a company. The market price of a single share tells you how much a small stake in the company is worth. Now, market capitalisation or market cap is the total value assigned by the market to all the equity shares of the company. Therefore, market cap is the market’s assessment of how much a listed company is worth. Using market cap is one way to classify companies.
Mutual funds in India classify their equity schemes as large-cap, mid-cap and small-cap. To do this, they go by the SEBI definition. SEBI has specified that after sorting all the listed stocks by their market cap, the top 100 should be treated as large-cap, the next 150 as mid-cap and all the remaining stocks in the market as small-caps. As the Indian market is made up of 5000-odd stocks, you can therefore see that small-caps is a very large segment indeed with over 4500 stocks in it.
The market is a moody animal and stock prices change every day. Therefore, a company’s market cap classification changes frequently too. To deal with this, the Association of Mutual Funds of India puts out a revised list every six months of what are considered large-cap, mid-cap and small-cap stocks by SEBI’s definition. As per the latest list for January-June 2023, the cutoff market cap for large-caps is at about Rs 50,000 crore. That for mid-caps is Rs 17,400 crore and everything below that cutoff is small-cap.
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Market cap versus quality
The above explanation tells you that while market cap is a convenient measure to classify listed stocks, it is not an actual measure of the size of a business, its quality or prospects. Yes, broadly the companies with the largest equity capital which also trade at high prices will fall into the large-cap bucket, the challengers could be mid-caps. But then, the market-cap based classification of companies results in sectors with large capital requirements such as banking, steel, oil and gas etc usually being counted as large-caps.
Whereas even great companies in sectors such as auto components, engineering or chemicals may only qualify as small-caps. The small-cap space can also feature leaders from sunrise sectors. As an investor therefore, it is important to stay away from the perception that all large-cap companies are bluechips with a great business and predictable prospects. You can find sector leaders and companies with sound management and potential in the mid and small-cap spaces too.
Less volatile
While good businesses may exist in any market-cap segment, there are two aspects on which large-cap companies offer a better alternative for investors in both stocks and funds. One, because they are the biggest companies in the market, large-cap stocks usually attract a lot of institutions both domestic and foreign to invest in them. In fact, today many global investors looking to take an exposure to India like to buy a basket of the largest stocks by market cap to represent the country. It is large-cap stocks that attract most of this money. This results in large-cap stocks falling less than the other market-caps during market corrections and crashes. They are also the first to lead any rebound.
Two, as large-cap companies are usually the biggest in their sector and can raise capital more easily than others, they tend to be more resilient to economic and business downturns. The earnings of large-cap companies tends to be far less volatile than the earnings of the mid-cap or small-caps. The lower earnings and stock price volatility makes large-cap stocks and funds a good choice for investors seeking a less volatile/risky exposure to equities. This is why large-cap funds and Nifty and Sensex funds are recommended to first-time investors.
At the other end of the spectrum, small-caps and micro-caps face much larger volatility both on the stock price front and in terms of their revenues and profits. They tend to deliver great returns when economic conditions are sound and the stock market is rallying. But at the first sign of a slowdown or a market correction, small- and micro-caps tend to suffer big reverses.
This is why your choice of whether to invest in large-caps, mid-caps or small-caps should depend on only two things. YouIn the worst years for the market, small-cap indices have fallen over 70% while large-cap ones have fallen 50%. Can you take that kind of a loss on your portfolio and hold on long enough for the next bull market to arrive?
Small-caps are also the last to participate in a bull market. So if you own a small-cap heavy portfolio, and a bear market arrives, you may need to hang on for the next 8-9 years to get back to a good return. With large-caps, the losses are shallower and the recovery is much quicker. That’s why no sensible advisor would recommend that you put all your equity money in small-caps, despite their recent returns. You need to mix and match large, mid and small-caps to manage the risks that come with returns.
(Host: Aarati Krishnan, Producer: Anjana PV, Camera: Siddharth Mathew Cherian, Amitha Rajkumar Moothedath)
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