Investing in big-cap versus small-cap stocks

THE argument as to whether big capitalisations are better than small ones has probably been around for about as long as stock markets have been in existence. It will probably never go away. Small-cap investors claim that they are on the lookout for the next DBS Group or the next DFI Retail.

We might be hard pushed to find a bank that could compete with DBS. But it might be easier to find a supermarket or retailer that could one day take on the Hong Kong-based pan-Asia retailer.

Big-cap fans, on the other hand, argue over the futility of looking for the next stock-market titan when we can already invest in real giants. They have a point. Stock markets have a plethora of large companies we can choose from. So, why should we bother trying to reinvent the wheel?

But there is a flaw in that assertion. The wheel today is not the same as the wheel that was carved out of stone in the Copper Age. The wheel, after all, has been reinvented and improved many times over. It will continue to evolve.

For instance, the high-performance sports cars on the road today could not possibly exist if not for low-profile wheels that allow for improved road handling.

Size isn’t everything

The point is that size is not everything. Large caps, or companies with sizeable market values, have advantages just as smaller outfits have theirs. There are also disadvantages associated with investing in large and small caps. Consequently, market caps, while a readily available metric that we can use to screen companies, should not be overused.

Investing should never be about placing restrictions on our search for good companies. That would be akin to restricting our diets to just one type of cuisine at the exclusion of all others. What a shame, given that there is an entire universe of foods that we can choose from. In a similar fashion, there is a wealth of small companies that might not look out of place in any well-balanced portfolio.

Many investors, however, prefer big companies because they are generally perceived to be less risky. Overall, they are. But there have been some notable calamities. So, it is not true that large caps are somehow immune from risk. They might have the resources to fend off impending challenges. But they are not completely immune.

The myth that large companies cannot fail has been put to rest effectively by the spectacular collapse of some well-known outfits. In the telecom sector, MCI Worldcom’s collapse in 2002 showed that even a US$180 billion company can fail.

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What investors need to remember is that all companies can crash regardless of their size, and the value of every share can effectively go to zero.

However, large companies are, in general, less prone to fail. Their more reliable revenue streams, coupled with a better and broader customer base, and greater scrutiny by analysts, make forecasting their performances more predictable.

Unfortunately, the price for that greater dependability could be pricier shares. Consequently, investors often complain that there are few, if any, bargains among the large caps.

Can it grow?

Many big caps have commanding positions in their respective marketplaces. In some cases, they may even have near-monopolistic positions. The clear advantage for big caps with dominant positions is greater pricing power and, consequently, higher profitability.

However, the flip side of this can be significantly slower growth. Companies whose products and services can be found in just about every part of the globe are naturally going to find it harder to expand. Small caps, on the other hand, have a lot more room to spread, and that expansion can usually be achieved organically, too.

That leads nicely to cleaner accounts. Investors like businesses that are easier to understand. However, big companies have a habit of complicating their businesses with mergers and acquisitions. That is often their only avenue for growth. This effectively results in very complex accounts that can flummox even professional number crunchers.

Another difference is liquidity, or the ease of buying and selling shares. The shares of large caps tend to be more liquid because there is an active market for their counters. Greater liquidity tends to mean that the spread between the buy and sell prices of their shares is narrower. Shares of small caps tend to be less liquid, making them harder to buy or sell.

Whether we like big caps or small caps, there is no substitute for proper research and a good understanding of the business. Investment guru Peter Lynch once said, “If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them.”

So, the question should not be whether big caps are better than small caps. Instead, it should be whether the company has good fundamentals, is fairly priced, and can reward shareholders with growth and income.

The writer is co-founder of The Smart Investor