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Market Capitalization and Why it Matters

If you ever invested, you have probably heard of market cap, which is short for market capitalization.  The calculation of market cap is pretty simple, it is the total number of outstanding shares of stock times the share price of the stock.  The price of a stock price is meaningless if you do not know the number of shares outstanding.  A company with a market cap of 1 million dollars could trade for $100,000 per share, but only have 10 shares. It would have the same value as a company that trades for $10 per share, but has 100,000 shares outstanding.  So saying a stock is too "expensive" for you to buy doesn't mean anything unless you know the number of shares outstanding.  The price of the stock does not affect its ability to change in price.  Look at Berkshire Hathaway (BRK-A), it is currently trading at well over $212,000 per share.  Last year on August 18th, it was trading closer to $202,000 per share.  The price of the stock did not affect its ability to grow by $10,000 per share in a year.  

Another example of where the price of the stock doesn't matter is a stock split.  Lets look at Netflix (NFLX).  On 7/14/15, the stock closed at $702.60 per share.  Then split the stock 7 for 1, and opened the next day trading at 99.97 per share.  However, if you owned Netflix, you now had 7 shares for every share that you owned prior to the split.  So the overall value of what you own did not change.  The only thing that changed was that an investor with only $1000 to invest can now buy 10 shares of Netflix instead of 1.  Will this drive the stock price higher? Probably not. 

Market cap is generally broken into 3 classifications; large cap, mid-cap, small-cap.  These days you will also hear nano-cap, micro-cap and mega-cap, but theses are relatively new terms.  All 3 classifications can be broken into subcategories by labeling them value or growth stocks based on their underlying fundamentals. We will blog about this at a later date.  

Large-cap companies are those with a market cap above $10 billion (mega-caps are above $200 billion). Many of these companies are names you would recognize, and you may hear them referred to as blue chip stocks.  They are considered relatively stable, and there are more dividend paying stocks in this category.

Mid-cap companies are those with market caps above $2 billion but below $10 billion.  This class of stocks are generally more volatile than large cap stocks, and have a higher percentage of growth stocks.

Small-cap companies have a market cap between $300 million and $2 billion (micro-cap is between $50 million to $300 million, and nano-caps are below $50 million).  Many of these are relatively young companies, which means they potentially have greater appreciation potential and greater risk.

Over time, these definitions have changed.  In the early 80’s, a market cap of $1 billion was large-cap, and now a $1 billion company is considered a small-cap.  Of all the publicly traded companies, 3.6% aer large-cap, 7.4% are mid-cap, and 52.2% are small-cap.

I'm sure all of this information is interesting, but why should it matter to you as an investor?  Well, it is important for a number of reasons.  For one, you need to look at the mix of companies in your portfolio to make sure you are not overly invested in one capitalization group.  If you are too concentrated in large-caps, you may not have enough growth potential in your portfolio.  If you are too concentrated in small caps, you may be taking on too much risk.  Diversification in company size will give you exposure to whatever part of the market is appreciating the fastest.  For example, throughout this most recent economic recovery, small cap stocks have lagged large cap stocks. This is unusual, but in this case, if you had too much of your portfolio in small cap stocks, you would have lowered your return.

Market capitialization is also important when you are evaluating mutual funds.  For example, we looked at Oakmark Equity and Income, a Moderate balanced fund, and they have approximately the following breakdown:

Large cap 36%
Mid cap 18%
Small cap 3.2%
International 6.6%
Cash 16%
Other 7%
Bonds 13.7%

Obviously they are underweight in small-cap compared to the overall market, and overweight in large-cap and mid-cap stocks vs. the market as a whole.  For a moderate fund, this is appropriate because mirroring the whole market and having over 50% in small cap would expose the fund to too much risk.