Market capitalization, which measures a company size in terms of the total value of its stock, can help identify the potential risks and rewards of buying individual stocks and mutual funds.
Historically, giants like Exxon, General Electric, and IBM, maintain slow and steady growth. They are market leaders and have earned the nickname “blue chip” for their relative security.
Smaller companies are often less predictable. They have less well know names, such as American Greetings Corp., or names that few people have heard of, such as Altra Holdings Inc. Some will become the next Google or Apple, some will muddle along in relative obscurity and some will fail.
The largest companies, those with a market cap of $200 billion, are known as “mega cap.” Companies with a capitalization of $10 billion to $200 billion are called “large cap,” while “mid-cap” companies range from $2 billion to $10 billion. “Small cap” companies have a market cap between $300 million to $2 billion. “Micro cap,” companies are valued at $50 million to $300 million, and “nano cap” companies have market caps below $50 million.
Capitalization is calculated by simple multiplication – the outstanding quantity of stock times the value of the stock- and is a rough estimate of how much a company would be worth if it were to be sold.
A tale of two stock indices – the large-cap S&P 500 and the small-cap Russell 2000 -shows why investors who are trying to balance growth and risk should consider a company’s size when purchasing stocks or mutual funds.
The S&P 500 Index, composed of the nation’s largest companies, hit a low of 676.53 when the stock market bottomed in March 2009. Thanks to a sustained stock market rally, the S&P 500 had gained more than 100 percent and closed at 1,355.66 at the end of April.
The S&P sits just shy of market highs reached in 2007, but it’s been outperformed by the Russell 2000 Index, made up of small companies with an average market capitalization of $1.26 billion. The Russell increased 143 percent from market lows when it hit an all time high of 868.6 on May 1, 2011.
Generally speaking, growth potential, as well as investment risk, increases as market size decreases. Even now, the economic tide could turn in favor of larger companies. Many analysts say small-cap companies are overpriced and vulnerable to a weak dollar and rising interest rates, and investors are urged to proceed with extreme caution when considering “micro” and “nano” cap stocks.
Investors can use the varying attributes of company size as part of a strategy for balancing risk and growth. The proper balance reflects an investor’s unique style, including income needs and tolerance for risk, and individual portfolios contain varying mixes of stocks, bonds, cash and alternative investments, such as real estate and precious metals. A more aggressive portfolio might include a high percentage of stocks, and these stocks may include a heavier concentration of more volatile small- and mid-cap companies.