Education: Growth & Income Investing

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Size Matters: Market Capitalization

Bigger is better. I am sure you have heard this before. Okay, get your mind out of the gutter; I am referring to company size. Larger companies typically fit the bill for growth and income investors. Let’s see why.

Defining and Calculating Market Cap

Market capitalization is simply a measure of corporate size. Yep, it is nothing more than that. This measure can be calculated by taking a stock’s price and multiplying it by the total number of shares outstanding (stock currently held by investors). In essence, it is the price one must pay to buy an entire company.

Let’s go over a quick example. If Moland Springs (fictitious company) is currently trading at $50 per share and has two million shares outstanding, its market capitalization would be $100 million. Sounds fairly big, right? Well, put it this way, General Electric’s market capitalization is over $350 billion. No, that is not a misprint. But that’s not to say Moland Springs is a small company.

Market Cap Breakdowns

There are a number of guidelines floating around with regards to the proper classification of company size by market capitalization. When all of these standards are analyzed, U.S. companies and stocks are often categorized by the following approximations:

Large-cap: market cap exceeds $5 billion

Mid-cap: market cap between $1 billion and $5 billion

Small-cap: market cap below $1 billion

You may also find the above classifications broken down even further. Mega-cap (the biggest boys) and micro-cap (the smallest fish) are terms you can also run across.

Risk/Return Tradeoff

Companies falling into either the large-cap or mid-cap buckets are typically well-suited for growth and income investors. Why you ask? Well, in general, large-cap and mid-cap stocks tend to be less risky than their small-cap counterparts. They are usually mature, well-established companies that have the necessary resources to weather an economic downturn. Smaller companies, on the other hand, are less-established and still trying to get off the ground and make a name for themselves.

However, one must keep in mind that with less risk comes slower growth. While small-caps have the potential to take off (but can also fail), large-caps may sometimes have limited growth potential. Mid-caps, as the name implies, fall somewhere in between. Their potential for growth is greater than larger companies, but so is the risk for loss.

Furthermore, mature and established companies have a higher tendency to pay dividends to their stockholders. While smaller companies are dumping money back into themselves in order to fuel growth, larger companies can afford to share their wealth with their shareholder base.

Conclusion

Growth and income investors are looking for companies that exhibit strong fundamentals such as earnings growth, strong management/leadership, excellent products and a competitive strategy. These are the necessary ingredients for a long-term hold. Large- and mid-cap stocks generally pass the test. We at Zacks like to limit our screen to companies with a market capitalization of at least $1 billion. As you can see from the guidelines above, this allows us to focus on both large- and mid-cap stocks. Small-cap stocks are left out in the cold.