When it comes to investing in large cap stocks versus small cap stocks and microcap stocks, several factors come into play. There are certainly risks involved in all market cap categories, and it takes a depth of knowledge and expertise to ensure that the right money is invested in the right opportunity at the right time.
Market capitalization is often linked to the risk/reward factor of an individual investment. Companies with smaller market capitalization are small cap stocks. They often feature higher growth, lower institutional ownership, and more volatility. Companies with larger market capitalization are large cap stocks – they are generally viewed as safer, with less volatility and more long-term institutional investors. Microcap stocks are the smallest companies (smaller than small cap stocks), and although they typically have the highest risk, they usually have the highest potential rewards. This breakdown offers a glance at the differences between the options, and information on which will make the right addition to your investment portfolio.
Investing in Large Cap v. Small Cap Stocks: The Advantages
Large cap stocks typically come with less risk because these companies are established, typically have repeat customers, generate higher earnings and cash flow, and have greater access to external capital than small cap stocks. Large cap stocks are generally considered a safer investment and are usually a more common choice for institutional investors and retail investors with lower risk tolerances. Large-cap stocks are often more established businesses with longer track records and a history of verifiable financial performance. Because large cap stocks typically have lower operational and capital risks, their expected returns are lower than small cap stocks and microcap stocks.
Small cap stocks, on the other hand, often require less investment capital up front for investors and therefore often offer a larger potential return. However, they often require frequent re-capitalization because their businesses are not as established or stable as large cap stocks and often burn through their cash. In other words, small cap stocks have higher solvency risks versus large cap stocks, and this can result in liquidity constraints, leading to lower institutional ownership and often greater volatility.
Microcap stocks have even higher volatility than small cap stocks. These tend to be earlier-stage companies that are not as established as companies with small cap stocks. They attract a smaller base of investors are who are willing to assume high early-stage company risks and as such, usually offer the highest potential long-term returns.
Some examples of large cap companies in North America include Apple, Exxon Mobil, Toronto-Dominion Bank, Sun Life Financial, and Shopify. Small cap companies in North America include companies such as Legend Power Systems, Lovesac, Emerge Commerce and Body and Mind.
Ultimately, large cap companies tend to grow at a steadier rate than small cap companies and come with less risk. Small cap companies are often younger companies that have not hit their peak (such as Sophic client Mijem), while large cap companies tend to be more mature and therefore more stable during times of economic instability (such as Facebook).
Risks and Considerations
It’s generally harder for a business to grow a $5 billion topline (large cap stocks) at 20% annually than a $5 million topline (small cap stocks and microcap stocks) at 20%. Although revenue growth provided by large cap stocks is typically far lower than 20% annually, it is far more stable and predictable. Twenty percent annual growth provided by small cap stocks and microcap stocks can easily flip to negative 20% should the economy take a downturn (such as during the 2020 COVID-19 pandemic), when they experience customer loss and/or key personnel turnover; or when they are poorly capitalized and face liquidity concerns.
Many investors tend to gravitate away from small cap stocks and microcap stocks due to the higher risks associated with these investments. Small cap stocks and microcap stocks have less stability, and despite their lower share prices versus large cap stocks, many small cap companies don’t have the maturity or financial performance of large cap companies. Small cap stocks and microcap stocks also come with solvency risks, since less business stability tends to reduce the size of the investor base willing to provide capital to fund future growth.
However, with greater risk comes a greater reward. Small cap stocks and microcap stocks do have higher risks than large cap stocks, but they can also lead to a larger potential for share price appreciation. Large cap companies tend to grow slower than small cap companies because they are more mature, stable businesses, offer more predictable financial models to determine proper valuations, and attract lower-risk investors that will trade volatility for operational predictability.
Hedging Your Risk
The ability to recognize when small cap stocks have the potential for significant price movements and returns should factor the increased risks. It is impossible to predict the broader market. Even meticulous models are imprecise, and analysis is easily voided upon new company, industry, or economic events. These augment risks when predicting what companies could become the next Amazon or Google.
Applying a buy-and-hold strategy when purchasing small cap stocks is ideal to maximize the probability for returns on your investment that meet your objectives. However, microcap stocks require far more scrutiny than large cap stocks. Loss of a key executive, an inability to raise capital, or the entrant of a strong competitor can all inhibit a company’s business outlook and pummel the stock. Buy-and-hold is a sound strategy but not in the absences of continuous, careful evaluation of the company, industry, and economy. Know what you won’t tolerate before you invest in any company and have the fortitude to act should something occur that threatens your outlook on the firm’s prospects.
Hedging your risk is also another option. Applying hedging techniques allows investors to safeguard capital invested in riskier stocks by offsetting the risk through alternate or additional investments. Diversification can on its own act as a hedging strategy – by adding small cap and microcap stocks to a portfolio build around large cap stocks, an investor can gain exposure to higher potential returns, while ensuring their total pool of capital grows over time.
But perhaps the best hedge is understanding your investment. Risk comes from not knowing what you are doing. One characteristic of small cap stocks and microcap stocks is that the lack of institutional and investment bank interest means management teams are willing to talk to retail investors. Within limits of what is public information, these management teams will talk about their businesses and answer questions to help generate interest. Management teams of mid-cap and large cap stocks typically don’t have much time to speak with investors because they are occupied with running their massive businesses. Knowledge is key – and speaking with management teams is a good way for investors to understand a business, its risks, and its opportunities.
There are also people seeking to secure their financial futures who do not have the interest, skill, or time to understand and evaluate businesses. For these people, purchasing microcap stocks, small cap stocks, and even large cap stocks puts them at risk. Two options are available for these types of people: i) invest in an index fund, as recommended by Warren Buffett, and ii) hire a professional financial advisor who will create and manage your portfolio for a fee under the guidelines of your investment objectives, risk profile, resources, and constraints.
Large Cap v. Small Cap Stocks: Comparative Performance in Canada and The United States
In the United States, small cap stocks continued to outperform large cap stocks in 2020 and into 2021. The Russell 2000 Index (for small cap stocks) has yielded a 13.5% return for investors in 2021 versus the 10.8% return on the Russell 1000 Index (for large cap stocks). Further, in 2020, the Russell 2000 Index reported a 18.3% growth rate while the Russell 1000 Index grew by 16.3%.
Historically, this is even more substantial: according to the Andex Charts, in the 62-year period between 1950 and 2012, small cap stocks in the United States outperformed stocks in all other categories, averaging a compounded annual growth rate of 13.4%.
In Canada, studies have shown that small cap stocks continue to outperform large cap stocks as well. The iShares S&P/TSX Small Cap Index ETF finished 2020 up 9.8% outpacing the iShares S&P/TSX 60 Index ETF which finished 1% higher year-over-year. However, as we have referenced previously, there is no reward without a certain level of risk. During the same time period, in the midst of a global pandemic that caused all markets to collapse, peak to trough for the small-cap ETF was -43.6% versus -32.4% for the TSX Index ETF.
Using the Economic Cycle as an Investment Guide
The economic cycle often plays a role in determining which investment should be added to a portfolio. During a typical year, the economic cycle fluctuates, providing different opportunities at different times. Stocks that follow the patterns of the economic cycle, including recession and recovery periods, are known as cyclical stocks.
While timing investments within the economic cycle can be difficult and tricky, it can be worth the payoff if the circumstances are right. This depends on the type of industry in which you are purchasing stocks. Large cap stocks typically have an added benefit from institutional holdings and lower volatility during times of economic recession, while small cap stocks tend to be more volatile and display more pronounced performance during these periods. Similar to our prior example regarding peak-to-trough price action during the 2020 pandemic, during peak cycles when economic growth leads to increased consumer spending, small cap stocks tend to increase quite rapidly as hopes around future earnings expectations overshadow current underlying fundamental performance.
Large Cap v. Small Cap Stocks: Key Takeaways
- While large cap stocks are mostly associated with more mature companies, small cap stocks are attributed to younger businesses and start-up companies.
- Large cap stocks are more stable businesses than small cap stocks and offer less investment risk.
- On a per share basis, it often costs less to purchase small cap stocks than it does large cap stocks, which when combined with increased volatility and higher growth tends to drive outperformance.
- Over longer periods of time, small cap stocks typically outperform large cap stocks in both Canada and the United States.
More About us: Sophic Capital
At Sophic Capital, we make it our priority to ensure our readers understand the risks, rewards, and factors that drive our clients’ businesses. With our experience covering equities across North America, we can help you better understand why we generally prefer to focus on small cap stocks versus large cap stocks. Subscribe to our mailing list to stay in the loop on the companies we represent, along with general market news and analysis. Alternatively, we’re always happy to answer your questions. Get in touch with us to talk to one of our team members.