Does a company’s market cap matter?

Does it make a difference having companies of different sizes (small-cap, mid-cap, and large-cap stocks) mixed into a portfolio? How do market valuation and business size factor into building a portfolio?

First, let’s define what we’re talking about. Market capitalization (“market cap”) is the total number of a company’s stocks multiplied by the value of the stock. That tells us the company’s total market value. A company with 10 million shares selling at $30 per share would have a market cap of $300 million. That’s a “small-cap” company, which typically have market caps under $2 billion. “Mid-cap” companies typically have a total market value between $2 billion and $10 billion, and “large-cap” companies have a market cap over $10 billion.

Different kinds of companies have different risk-and-reward profiles. Large-cap companies are typically more stable and pose less risk but also offer less growth potential. Small-cap companies are the opposite: riskier and more volatile but offering a lot of growth potential. That’s because these smaller companies:

• Have relatively limited resources,

• Are more vulnerable to competition and market conditions,

• Aren’t generally as proven, but

• Have a lot of room to grow, and

• Pay out better when they perform beyond expectations.

We can even quantify these differences at a high level: according to Investopedia, the Russell 2000, an index of small companies, returned 8.6% on an annualized basis between 1997 and 2012. That’s nearly double the 4.8% returns from the S&P 500 (which is mostly large-cap companies) during the same period.

However, the Russell 2000 also showed one-third higher volatility, which means it fluctuated a whole lot more than the S&P 500 throughout that period.

Nearly double the returns sounds great, right? But we shouldn’t underestimate the volatility involved. Imagine what it would have been like being an investor all the way from 1997 through 2012 and watching prices move all over the place, including taking sudden downward plunges. It’s very hard to watch a price plummet and not think, “Oh, I need to sell before it’s too late.” Or, conversely, to see a sudden spike in value and not think, “I need to sell before it goes down again.”

The truth is that a lot of investors just don’t have the patience or emotional fortitude to tolerate that kind of volatility. That’s why I tilt my own choices toward mid- and large-cap companies. Don’t misunderstand me: there’s money to be made in small-cap equities. In fact, I’d argue there are a lot of cheap things to do in the sub-$1 billion market right now. They’re like any other investment: if the fundamental valuation of the business is correct, it doesn’t matter if prices go up and down in the short-term because I can reasonably expect a long-term payout.

But I handle investment portfolios for other people with a lot of transparency, which means they can see the trades I’m making basically in real-time. I have found that most people just don’t have the stomach for the kind of wild fluctuations you find in the small-cap area. A small-cap focused investment business is just not a marketable product from my perspective.

If I could own a hundred different companies and thus maybe smooth out the volatility, having a greater number of small-cap companies would be fine. But are there genuinely a hundred good ideas at any given time? Probably not, and I'm not willing to give up the focused nature of my portfolio construction. Ultimately, I want to own around 15 to 20 companies.

So, to answer the question directly, a company’s market cap doesn’t really matter as long as your underlying assessment is sound. A lot of these smaller businesses offer tremendous growth potential! But you have to have the stomach for a wild ride in price volatility, and that’s not a trivial thing. It’s the reason I tend to favor mid-cap and large-cap stocks in my own work.