This is a guest by Erik, he blogs over at The Mastermind Within. If you enjoy this post then please check his website out. It has some really good content on there.
Many investors have the following questions: which companies should I include in my investment portfolio for the best returns? Should I have the biggest companies? Do companies with lower market capitalization outperform companies with large market capitalization?
In this post, I will compare the performance of Large Cap, Mid Cap, and Small Cap Equities from a qualitative and a historical perspective.
What is market capitalization?
First, let’s define market capitalization.
Market capitalization is the sum of the value of all outstanding shares of a company. For example, if company XYZ has 10 shares outstanding and the share price is $100, the market capitalization of company XYZ is $1,000. Market capitalization is commonly referred to as “market cap”.
Companies are classified by their market cap. There are three common classifications:
- Large Market Capitalization Companies (“Large-cap”)
- Large-cap companies typically have a market capitalization of $10 billion or more.
- Middle Market Capitalization Companies (“Mid-cap”)
- Mid-cap companies typically have a market capitalization between $2 billion and $10 billion.
- Small Market Capitalization Companies (“Small-cap”)
- Small-cap companies typically have a market capitalization between $300 million and $2 billion.
Large Cap Companies
Large-cap companies are the major players in well-established industries.
These companies have been around for many years, and most likely are not looking to take much risk. As a result, investing in large-cap companies will most likely not have a tremendous impact on your portfolio in the short-term. However, over a longer time horizon, these companies will provide value through a consistent increase in share value and steady dividend payments.
Mid-Cap companies are established companies which are still growing. Mid-cap companies usually operate in industries which are expected to grow in the future. Most companies have some debt and are still trying to establish themselves as a top player in their industry.
Mid-cap companies have slightly higher risk than large-cap companies because they are not as established. That being said, mid-cap companies have a higher potential for growth.
Small-cap companies are generally younger companies which have a lot of potential to grow. Typically, small-cap companies serve niche markets or industries which are still growing.
Investing in small-cap companies is considered a higher risk investment because of their age, their size, and the markets they operate in.
In addition, small-caps usually are in debt and leveraged to the economy. During rough times, small companies will fail because they don’t have the operational power and reserves to handle losses.
Qualitative Assessment for Performance
Small-cap companies should perform better, on average than large and mid-cap companies because of the asymmetrical risk/return. Yes, there more opportunity to grow for small-cap companies, but there is also more downside risk.
Large-cap and mid-cap companies have stronger operations and more reserves to handle losses in tough times. While share values may decrease substantially, there is opportunity to rebound and recoup those losses when the economy recovers.
Mid-cap companies should perform better than large-cap companies because they are still in the growth phase. While not as highly leveraged as small-caps, the mid-cap companies are still looking to grow and build their brand at a rapid pace.
Historical Performance Comparison of Large, Mid, and Small-cap Companies
To compare the historical performance of Large, Mid, and Small-cap Companies, I went to the Vanguard website to find the Large, Mid, and Small-cap index funds. Next, I used their comparison tool to examine the historical performance.
As shown below, the relationship between market capitalization and market performance has an inverse relationship. The Small-cap Companies have experienced higher gains than the Mid and Large-cap companies.
One thing to note, I wanted to look at these funds since inception, but the inception dates for these funds were not the same. The Vanguard Small-cap Index Fund was created in 1960, the Vanguard Mid-cap Index Fund in 1998, and the Vanguard Large-cap Index Fund in 2004. The analysis showed the same conclusion of Small-cap’s outperforming Mid and Large-caps.
Performance of Small, Mid and Large Cap Index Funds – Vanguard
The inverse relationship between Small, Mid, and Large-cap companies makes sense due to the intuitive points made above.
When deciding what to invest in, be aware of the different sizes of companies. Large-cap companies will be more stable, but will not have a huge potential for growth. Small-cap companies have more room to grow, but also have a higher chance of losing value.