When you have a few extra bucks on hand to start investing, would a dividend-paying famous multinational company which your investor peers often talk about entice you, or would you rather allocate it to a quiet small cap company that maintains solid financials and constant growth while simultaneously offering great future prospects?

While there will be no one-size-fits-all answer, here’s a few things that investors should consider when looking to invest in large cap or small cap companies. 

What is market capitalisation?

When investors discuss large-cap and small-cap stocks, they are referring to the market capitalisation, which is the value of a company’s outstanding shares. 

Market capitalisation is calculated by multiplying the total number of shares by the share price. If a company has 10 million shares priced at $10 each, its market cap would be $100 million. 

Large-cap stocks have higher market caps, indicating larger companies, while small-cap stocks have lower market caps, indicating smaller companies. Market cap reflects how investors perceive a company’s value, which can be influenced by various factors such as short-term optimism and long-term growth expectations.

Types of market capitalisation

Large caps

These are the biggest companies on the ASX in terms of market cap. The S&P/ASX 50 (AFL) index represents the top 50 companies. The market cap of these securities generally cover those valued at more than $10 billion.

Mid caps

These are the next 50 biggest companies on the ASX in terms of market cap. The S&P/ASX MidCap 50 (XMD) comprises the members of the S&P/ASX 100, excluding those in the S&P/ASX 50. The market cap of these securities generally ranges between $2 billion to $10 billion.

Small caps

These are all those companies that sit outside of the largest 100 on the ASX by market cap. The S&P/ASX Small Ordinaries index (XSO) represents those smaller members of the S&P/ASX300 index. It’s used as a benchmark for small cap Australian shares. Companies in this index generally have a market cap of between $20 million to $2 billion.

Micro caps

Publicly-traded companies which have a market capitalisation under $20 million are classified as micro cap companies. These companies are often at an early stage of development and may operate in niche markets.

Why invest in small-cap stocks?

Growth Potential

Small-cap companies are typically in the early stages of development and can experience significant growth if successful, even possessing higher growth potential compared to large caps.

Undervalued Opportunities

Small caps, often overlooked by institutional investors, can present opportunities for retail investors.Due to limited analyst coverage, there may be pricing inefficiencies and misperceptions about the company’s true value. However, a thorough research might be able to help uncover hidden gems trading at discounted prices.

Flexibility
Small-cap stocks can quickly adapt to changing market conditions, implement new strategies, and seize emerging opportunities. This flexibility allows them to respond swiftly to market dynamics and potentially outperform larger, more bureaucratic competitors.

Less Affected by Inflation and Recession: 

Small cap stocks are price-takers not price-makers, so are penalised less by inflation. 

According to a Goldman Sachs report, small-cap stocks tend to outperform large-cap stocks during recessions. Historical data shows that the average long-term returns for US small-cap stocks during recessions since 1936 were around 11.7%, while large-cap stocks averaged 8.4% during the same period.

Risk of investing in small caps:

Higher Volatility

Small-cap stocks are generally more volatile than large-cap stocks. They can experience significant price fluctuations, which may be due to factors such as market sentiment, liquidity constraints, or limited financial resources.

Liquidity Challenges

Small-cap stocks often have lower trading volumes, which can make it difficult to buy or sell large quantities without impacting the stock price. This illiquidity can pose challenges for investors who need to exit their positions quickly.

Higher Failure Rate
Smaller companies face a higher risk of failure compared to more established, large-cap companies. Limited financial resources, competition, and other market challenges can make it challenging for small-cap companies to succeed.

Limited Resources and Information: Small-cap companies may have limited resources for research and development, marketing, or expansion. Additionally, they may provide less public information and financial disclosures compared to larger, more regulated companies, making it harder for investors to evaluate their prospects.

Investing in small-cap stocks requires careful research, due diligence, and a long-term investment perspective. It may be suitable for investors who are willing to tolerate higher risk and seek the potential for outsized returns in their portfolio.

Why choose large caps?

Stability and Reliability

Large-cap stocks are typically well-established companies with stable earnings and a proven track record, providing a sense of stability and reliability.

Dividend Potential
Many large-cap companies pay dividends, making them attractive to income-focused investors seeking regular cash flow.

Market Leadership
Large caps often have dominant market positions and strong brand recognition, which can provide a competitive advantage and reduce risk.

Lower Volatility
Large-cap stocks tend to be less volatile compared to small caps. They are often less susceptible to drastic price swings and market fluctuations.

Risk of investing in large caps:

Limited Growth Potential
Large-cap stocks are often already established and may have limited room for significant growth compared to smaller, high-growth companies. As companies reach a certain size, it becomes more challenging for them to sustain high growth rates, and their stock prices may reflect this slower growth potential.

Management Challenges:
Though this might happen to companies of all sizes, as companies grow larger, their management structures can become more complex, potentially leading to bigger challenges in decision-making, coordination, and execution compared to smaller cap companies with smaller management size.

Lack of Agility and Innovation
Large-cap companies may struggle or react slower when adapting to rapidly changing market dynamics and technological advancements. Their size, existing bureaucracy, and established processes can make it difficult to quickly pivot or embrace disruptive innovations, potentially resulting in missed growth opportunities or losing market share to more agile competitors.

Dependency on Macro Factors
Large-cap companies tend to have greater exposure to macroeconomic factors due to their size, market dominance, and broader geographic reach. Changes in economic conditions or government policies can impact consumer spending, business investments, and overall market sentiment, affecting the performance of large-cap stocks.

Should I invest primarily in small cap or large cap stocks?

The decision to invest in large-cap or small-cap stocks depends on various factors, including your investment goals, risk tolerance, investment timeframe, and portfolio diversification strategy. Conducting thorough research, monitoring market conditions, and maintaining a long-term investment perspective can help navigate the potential risks of investing in both small-cap and large-cap stocks.

Large-cap stocks may be suitable for conservative investors seeking steady growth and income. Small-cap stocks, on the other hand, may provide higher growth potential but with increased volatility and higher risk. If you have a higher risk tolerance and can handle short-term price fluctuations, small-cap stocks may be suitable. However, if you prefer more stability and are more risk-averse, large-cap stocks may be a better fit.

It is important to evaluate your investment timeframe. Small-cap stocks, although more volatile, have the potential for significant long-term growth. If you have a longer investment timeframe and can tolerate short-term market fluctuations, investing in small-cap stocks may allow you to capture their growth potential over time. If your time horizon is shorter or you need more stable returns, large-cap stocks may be a more appropriate choice.

All in all, diversification across different market caps and asset classes is often recommended to spread risk and capture opportunities. A well-balanced portfolio may include a mix of large-cap and small-cap stocks based on your individual circumstances and investment strategy.