Trading / Small Cap stocks

What is Small Cap vs Large Cap

  • Declan O’Flaherty

    Declan holds a Bachelor of Commerce from the University of Alberta and has over 4 years of experience investing in financial markets. As a fundamental investor, Declan embraces the investment principles of Warren Buffett and his disciples. This puts a focus on finding businesses with healthy financials, competent and accountable leader, enduring competitive advantages, and those that are selling at discount to what they are worth.

    View all posts

rocks balancing on rocks

The stock market is an incredible investment vehicle, filled with wonderful opportunities for amassing a fortune.

But with so many companies, all varying in size, experience, skills, and luck, knowing which ones to choose might feel like an incredible feat on its own.

A great first step is to know the differences between small-cap and large-cap stocks.

Since both markets come with unique strengths and weaknesses, retail investors should understand both, and decide which one is the most suitable based on their investment style and needs.

In this article, we break down:

  • what is a small cap vs. large cap stock; 
  • what are the advantages of investing in small cap vs. large cap stocks; 
  • which of these markets has performed better historically; 
  • and how to decide which market you should invest in.

What is a Small-Cap Stock

A small-cap stock is a business with a market capitalization between $300 million and $2 billion.

For those unfamiliar, market capitalization is calculated by multiplying a company’s stock price by the total number of shares outstanding.

Investors looking to invest in the small-cap market typically do so because they anticipate the stock to grow into the large caps of the future, thus providing them with astronomical returns.

Due to their size, small-cap stocks are often considered riskier investments because they tend to be more volatile than larger businesses.

With smaller number of buyers and sellers of small-cap stocks, and less support from large institutions, the difference between the bid and ask price can be at times large, causing significant fluctuations in the daily share price.

That being said, this volatility in stock price is not indicative of the actual inherent risks within the business, and can at times create incredible buying and selling opportunities for those keeping a close eye on the market.

A common misconception is that small-cap stocks are typically startups with only a little revenue to show for, yet in actuality, many small-cap companies have strong track records, a healthy balance sheet, and are growing naturally through solid business fundamentals.

While small-cap stocks generally fly under the radar because most people are unfamiliar with them, and media outlets rarely cover them, there are many excellent investment opportunities available in this market.

For more information on small-cap stocks, check out our article on “What is a Small-Cap Stock.”

Three advantages to investing in small-cap stocks

Chess pawn with a crown on its head

1. Superior growth potential

Given their size, the likelihood of a small-cap stock doubling, tripling, or even hitting the prized ‘10X’ (which occurs more often than you might think!) is much more possible than for a large-cap business like Apple (AAPL) to do the same.

To elaborate on this argument, here is an example:

Since Apple is the largest company in the world based on market cap, valued at $2.7 trillion, the tech giant would have to create value equal to what they have done over its entire history to double its market cap.

As the $5.4 trillion mark has yet to be achieved by any business, and the value created by a company diminishes over time, it is nearly impossible that Apple, or any company for that matter, would reach this feat in the foreseeable future.

Instead, if you were to invest in a small-cap business that is valued at $2 billion, 0.07% the size of Apple, the ceiling of growth is much higher for small-caps meaning that your stock generates more favorable returns.

Keep in mind that even though this is possible, a business’s stock price should always reflect the value being created by the company.

If a company has a poor management team, massive debts, and its product or service is of terrible quality, then it may never surpass that $2 billion mark, and instead, dwindle into nothingness.

2. Better opportunities for retail investors

Like the businesses we invest in, investors come in all shapes and sizes with different amounts of capital that they are managing.

For example, the investment firm BlackRock manages over $9.6 trillion in assets, according to Statista, whereas many retail investors might be working with only a few hundred dollars.

As such, the investment opportunities available to investors vary depending on your size and the kind of assets you have readily available.

Fortunately for us retail investors, we possess a significant advantage compared to our larger counterparts because the number of assets and opportunities out there is exponential in comparison to large investment managers and funds.

Similar to the Apple example mentioned earlier, once you reach a certain size, it is more difficult to grow effectively because the number of investments worth your while diminishes the larger you become.

For a firm as large as Black Rock to invest in a small-cap stock, they would have to buy nearly the entire company to meet their minimum investment requirement, which warrants the amount of research they would need to undertake to make the investment.

As a bonus, retail investors possess another advantage due to their size because they can exit a position much quicker than a firm like Black Rock; it is most often the case that there are plenty of buyers out there willing to purchase a couple of thousand dollars worth of stock.

3. Investing for the future

Investing in small-cap stocks is like investing in the large-cap stocks of tomorrow.

While most small-cap companies will fail to reach this feat, those who do will provide early investors with life-changing amounts of money.

Since retail investors have the opportunity to buy into these companies before larger investors even have a chance, you as a small-cap stock investor are likely to capture more of the returns provided by the company if you hold on to it for an extended period of time. 

The key to maximizing these returns is to remain an owner for the long run and possibly even forever.

The longer you hold on to an excellent business, the greater the wealth you will acquire.

To increase your likelihood of success when investing in smaller companies, check out our article on “How to Make Money with Penny Stocks.”

What is a Large-cap Stock

corporate office of a company

According to Investopedia, a large-cap stock is referred to as any company with a market capitalization of more than $10 billion.

Made up of some of the world’s most recognizable businesses like Google (GOOG) and Tesla (TSLA), large-cap stocks tend to generate more investment activity than smaller companies because investors are most familiar with their brands and business models.

Interestingly, there are only 778 large-cap stocks in the US, compared to the 7,807 stocks available on the market, yet their total market cap captures over 87% of the entire market value.

As demonstrated, most of the capital trading in the stock market floods into large-cap stocks, and for good reason.

Many of them are proven winners.

While not always the case, large-cap stocks generally achieve such tremendous size because they create value for their customers on a level that most businesses will never realize.

Since there are still instances where a large-cap stock will crash and burn, it is important to be vigilant when assessing any business because you never know what you might discover when the truth is revealed.

For those looking to add large-cap stocks to their watchlist, check out the major US stock indexes like the S&P 500, Nasdaq 100, and Dow Jones Industrial Average, which are mostly US large-cap stocks.

Three advantages to investing in large-cap stocks

1. Proven track record with many years of experience

Unlike most small-cap stocks, large-cap stocks are likely to have traded on public markets for quite some time, meaning that they are required to disclose their financial information since their initial public offering (IPO).

This is a massive advantage for investors because you can conduct a personal investigation into whether or not the business is performing well over an extended period, and also determine if the company’s management is following through with their promises of the past.

Not only that but looking into a business’s track record is an excellent way to find out where a stock is headed in the next few years.

While it is true that a business’ past successes are not indicative of how it will perform in the future, looking into the numbers provides a clearer picture of where it is headed compared to not looking into them at all.

As renowned writer Mark Twain once said:

“History Doesn’t Repeat Itself, but It Often Rhymes”

If you are interested in exploring a large-cap stock with an extensive history, check out Coca-Cola’s (KO) 103 annual reports since its IPO in 1919.

2. Opportunity to buy the best businesses in the world

Most large-cap stocks achieved their size for good reason.

While there are certainly instances of fraud and corruption, like the Enron scandal, a business that surpasses a $10 billion market cap has done so because they create value for their customers on a level few are likely to achieve.

As such, the value they provide is reflected in their stock price because investors favor its likelihood of success over some unproven stock that their uncle talked about during thanksgiving dinner.

At a certain point, if a company can create a significant competitive advantage, it is even possible that they reach a size so large that it is nearly impossible for it to fail (think banks during the 2008 financial crisis)

For example, if you imagine some of the biggest brands in the world, the reason they are so well known is that they had brilliant people in place and an exceptional business model that enabled them to reach that point. 

Suppose they can continue upholding their favorable reputation and provide high-quality value to their customers.

In that case, they are sure to endure well into the future regardless of how the economic environment plays out.

That being said, whether the business is a no-brainer or a potential bust, one should always conduct a thorough analysis of a company because there is always the chance it fails, no matter how massive the business is.

3. More predictable results

When analyzing a company’s financial statements, it becomes clear that the more years of information available, the more likely it is that you can find patterns or trends developing in the business.

Once again, large-cap stocks are advantageous in this area because you can see over many years whether a poor financial year is a one-off or a growing problem.

This is less so the case with smaller companies because there are often fewer years to reference meaning that it is more difficult to determine inherent flaws in the business.

Additionally, many large-cap companies have grown to such a size that the fluctuations in financial performance begin to stabilize, meaning that their results are more consistent, thus making it easier to predict where the business is headed.

All in all the more predictable a business’s financial statements are, the greater confidence an investor has when investing in a stock for the long run.

Which is better: Small-Cap or Large-Cap

Chart showing the performance of stocks compared to inflation

Now that we explored what is small cap vs. large cap, and the advantages of investing in these different types of asset classes, it is time to see who has performed better historically.

According to Aswath Damodaran, small-cap stocks performed better than large-cap stocks during high inflationary periods (like the one we are currently experiencing) and they also performed better in the long run, posting returns of 1,990% compared to 1,715%, over 30 years.

While the past is no indication of what might happen in the future, it is clearly beneficial for investors to consider investing in small-cap stocks because of the superior return potential available in this market.

One explanation for this outperformance can be attributed to the advantages mentioned earlier, where the size of the business ultimately affects how much more a business can grow.

If you’d like to learn more about how each asset class performed historically, check out Longtermtrends for more charts like the ones you see here.

How to decide between small cap vs. large cap

Chart showing the performance of various equity classes

While it is evident that both large cap and small cap stocks possess their unique advantages, the simple answer for whether one should invest in either, is that they should invest in both.

Notice that in the charts presented above, each asset class generated excellent returns for investors, especially compared to storing your money in a savings account.

If preserving your wealth is more important than growing it, it might be worthwhile to invest more in large-cap stocks because of their size, reputation, and predictability.

On the other hand, if you are looking to significantly change your financial situation for the better, then small-cap stocks are a worthy investment for any portfolio because they offer incredible growth potential.

All-in-all, both asset classes are excellent at creating wealth for you and your family.

What is important now, is deciding your risk appetite and whether you are willing to embrace more of it to generate greater returns.

 

 

 

 

Disclosure/Disclaimer:
We are not brokers, investment, or financial advisers; you should not rely on the information herein as investment advice. If you are seeking personalized investment advice, please contact a qualified and registered broker, investment adviser, or financial adviser. You should not make any investment decisions based on our communications. Our stock profiles are intended to highlight certain companies for YOUR further investigation; they are NOT recommendations. The securities issued by the companies we profile should be considered high risk and, if you do invest, you may lose your entire investment. Please do your own research before investing, including reading the companies’ public filings, press releases, and risk disclosures. The company provided information in this profile, extracted from public filings, company websites, and other publicly available sources. We believe the sources and information are accurate and reliable but we cannot guarantee it. The commentary and opinions in this article are our own, so please do your own research.
Copyright © 2023 Edge Investments, All rights reserved.

  • Declan O’Flaherty

    Declan holds a Bachelor of Commerce from the University of Alberta and has over 4 years of experience investing in financial markets. As a fundamental investor, Declan embraces the investment principles of Warren Buffett and his disciples. This puts a focus on finding businesses with healthy financials, competent and accountable leader, enduring competitive advantages, and those that are selling at discount to what they are worth.

    View all posts

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