Home Beginner Market Structure Understanding The Basics Of Market Capitalization – Small Cap

Understanding The Basics Of Market Capitalization – Small Cap

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Introduction to Market Capitalization

Metaphorically speaking, a market in a country is an ocean. The market can be classified into many subdivisions. A market can be classified into the stock market, indices, monetary markets, and commodities. Again, each classification has sub-classifications. Here we will be discussing the stock market. The stock market is categorized based on market capitalization and market sectors. Small cap, mid cap, large cap, micro cap, and penny stocks are included in market capitalization. Let’s understand in detail about what small cap means in the stock market.

What is Small Cap?

Small-cap stocks or companies are the companies whose market capitalization is small. Where market capitalization is the value of a company it has in the stock market. In other words, it is the market value of outstanding shares. It is calculated by multiplying the total number of shares with the current share price. The definition of small cap lies in the name itself; as “cap” in small-cap refers to capitalization. If the market capitalization of a company lies between $300 million to $2 billion, it is considered as a small cap company.

For example, a company has a current share price of $50 and has a total of 15 million shares. We know that, market capitalisation= current share price * total number of shares = $50 * 15,000,000 shares = 750,000,000 (750 million). This number lies within the range mentioned above and hence can be considered as a small-cap stock.

Also, note that the total number of shares holds more significance than the present share price. The share price can be high, but the number of shares is the parameter that determines its capitalization. The market capitalization of a company can vary with time. A company can move from small cap to mid cap or vice versa.

A common tendency is that individual investors are more into investing in small-cap companies than institutional investors. Institutional investors typically purchase a large number of shares of a company. When they invest in large-cap companies, their purchase is worth a small percentage of the company’s shares. But, a purchase in the shares of a small-cap company, they hold a significant percentage of the company’s shares.

To hold such a large amount of shares, the institutional investors must undergo the SEC filing process. This is then known to the public, which inflates the stock prices, and they will have to buy the shares at higher prices. Hence, it becomes difficult for the investors to make out of that stock. On the other hand, individual investors deal with a lesser amount of shares, which does not require SEC filing to be done. Hence, they have this advantage over institutional investors.

Small-cap companies usually do not pay dividends. A simple reason is that they want their capital to grow. Therefore, small-caps are good investment options for people who don’t require fixed income from their portfolios. Also, individual investors don’t prefer investing in small-cap companies as they don’t have enough history to research about the company. So, they rather prefer small-cap mutual funds as the analysts there will have sufficient information to research about the company.

Difference between Small Cap and Large Cap

As a usual trend, small-cap stocks are generally very volatile. They generate high returns as well as have drastic drops. Therefore, an investor must be extremely careful while investing in small-cap companies. The timing for entry and exit in the market is very crucial too. Coming to the large cap stocks, their market capitalization is *$10 billion or higher. And generally, these stocks, unlike the small cap stock, are not very volatile. They are comparatively less volatile and are more stable than the small-cap stocks. Conservative investors usually prefer the large-cap stocks over small-cap stocks as they tend to provide safer returns. Their return might not be as high as small-cap stocks, but their returns are more reliable than small-cap stocks.

Difference Between Small Cap and Mid Cap

First of all, mid-cap companies are those whose market capitalization is between *$2 billion and $10 billion. Having this balanced market cap, these stocks have the required stability in the market without compromising the returns. Again, these stocks are relatively less volatile than small-cap stocks, and also do not provide high returns in less amount of time. Nevertheless, these stocks are seen to generate better returns than large-cap stocks. Also, the mid-cap stocks have performed better than small caps and large caps over the last 10 years. Therefore, smart investors usually are keen on putting their money into the mid-caps than the other two sectors.

Small cap indexes and ETFs in the US

Indexes of a country represent the overall performance of a group of stocks. Based on market capitalization, there are different indexes of each type. The most focused index for the small-cap companies is the Russell 2000 Index. Russell 2000 is an index created by the Frank Russell Company in the year 1984 which consists of 2000 small-cap companies from the Russell 3000 Index. Where the Russell 3000 Index is made up of 1000 large cap companies (Russell 1000 Index) and 2000 small-cap companies (Russell 2000 Index). The Russell 2000 Index is used to measure the performance of the small-cap companies. It basically gives a bird view on how the small-cap sector is performing. Other small-cap indexes also include S&P 600, the Dow Jones Small Cap Value Total Stock Market Index, and the Dow Jones Small Cap Growth Stock Market Index.

An Exchange-Traded Fund (ETF) is a collection of securities that is mainly used to track an index. Unlike Mutual funds, these can be traded in the market just like a stock. The iShares Russell 2000 Growth ETF is a small-cap fund that tracks the Russell 2000 Index. Similarly, iShares Cores S&P Small-Cap ETF is another small-cap fund that tracks the S&P small-cap 600.

Small cap indexes and ETFs in Europe

The EURO STOXX Small Index is an index that is composed of the small-cap companies in the Euro Zone. This index is derived from the STOXX Europe 600 Index, which provides a representation of the large, mid, and small cap companies in the Euro Area. Other small-cap indexes in Europe are the MSCI EMU Small Cap Index, the MSCI Europe Small Cap Index, and the STOXX Europe Small 200 Index. All of these indexes consist of small cap securities.

Coming to the ETFs, iShare EURO STOXX Small UCITS ETF is an ETF that focuses on investing in the small-cap companies of the EURO STOXX Small Index. Similar to this is the iShares STOXX Europe Small 200 UCITS ETF which tracks the performance of the stocks in the STOXX Europe Small 200 Index.

Small Cap companies’ impact on the economy of a country

Small cap companies play a major role in job creation. This is because small-cap companies are still under development, and there is always a requirement for jobs in different fields. Therefore, job creation will have a positive effect on the economy of a nation.

Is investing in Small Caps, a risky business?

Yes, indeed. Small caps are riskier than large caps and mid caps. These companies are growing companies, so one can expect higher returns when having a long term sight. These companies do not have the resources of large-cap companies; hence, they have a greater chance of seeing drastic falls. Therefore, these stocks are usually volatile. Also, the investment gets riskier during the contraction phase. So, a decrease in demand, the stocks observe a huge dip. Therefore, it can be concluded that the higher the risk the better the reward. Contrarily, Lower the risk, lesser is the reward. Here, small-cap stocks come under the high-risk category. Hence, only the investors with all the research and knowledge about the company can find a way to make good returns from the company.

*The classification of companies as small cap, mid caps, and large caps varies from broker to broker.

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