Welcome to Finance and Fury. Where to invest within the share market? Large, mid or small cap? What is best?

The answer to this is highly dependant on what types of returns you need – and your timeframes

The content of this episode is general information only – Not personal advice or taking into account your personal situation

To start with some of the basics – what does large, mid or small cap actually mean?

  1. Cap is short for capitalisation – which for a listed company on the share market is worked out by multiplying its current share price by the number of outstanding shares on the share market
    1. As an example – BHP has roughly 5bn shares – at a price of just shy of $48 at the time of recording this episode, it has a market cap of around $242bn – which is the largest company on the ASX by market capitalisation
    2. Capitalisation of a company plays a major role in index investing – as it determines the allocation of the investments – this is due companies being included in these indices based on the daily average market cap of their shares over a period of time
  2. What is considered large, mid and small cap –
    1. There is no universal definition for large, medium, or small cap companies and different markets divide them according to different characteristics
    2. Changes with international shares – But as a general rule –
      1. large-cap shares have a market cap of $10 billion or more
      2. Mid-cap shares from $2bn to $10bn
  • Small-cap shares generally have a market cap of $250 million to $2 billion
  1. Two other categories being mega-cap – which is relatively new, and microcap – Mega-cap would be for companies with a market cap above $200bn and microcap for shares with a smaller market cap than $250m
  1. Beyond their size – what are some generalisations about the characteristics of companies within each of these capitalisation categories?
    1. Large cap – These companies are also called blue-chips – this basket includes companies with a history of dependable earnings, solid reputations, and strong financials – generally to reach a size where a company is worth more than $10bn, it needs to not only been around for a while, but had a successful journey – in the US, companies like Microsoft, Alphabet, MasterCard would be considered in this category – in Australia – most companies in the top 20 would be considered blue chips – BHP, the banks, WOW and COL/WES, TLS, etc.
      1. In general, large-cap shares are established, mature, and stable companies – as such, they can tend to be less volatile than smaller companies in the market and provide a stable dividend stream
      2. Whilst these companies tend to perform well and provide returns that are safe from an absolute loss for investors – they are not immune from short term volatility – some large cap companies can see a decline of more than 50% of their values in market corrections
  • Whilst chances of absolute losses are also lower than a small cap resource company, there have been several cases in history that point to the opposite
    1. Enron is one of the more famous examples – this was a darling of the energy industry – but was the subject of an accounting scandal, where they used accounting methods make it look much more profitable than it actually was – some subsidiaries were losing money, but the company continued to hide its losses and debt and ended up filing for bankruptcy
    2. Lehman Brothers – had a market cap of $60bn just before their collapse – These serves to demonstrate that the bigger they are, the harder they fall
  1. The lesson? Just because it’s a large-cap doesn’t mean it’s always a great investment and safe from losses – particularly if you are not diversified
  1. Mid-Caps – The market cap of these securities generally ranges between $2 billion to $10 billion.
    1. In Australia – These companies are normally represented by those companies outside of the top 20 ASX companies, but not below the 100th company – these are still large companies, but not all of these will have a long term track record – some will be overnight successes and soon lose their place in the mid-caps – but there is more of a mix the smaller the market cap becomes – some companies have been around for a long time, have stable and growing cashflows, and be able to consistently pay dividends – others, may be the new kids on the block and only be in this space due to investor – an example would be ZIP – over a very short span of time reached a market cap of $9.5bn at its peak – but just 18 months later, being now – down to $500m in market cap – was fuelled off the speculative bubble around buy now pay later businesses that were yet to turn a profit – and in a low interest rate environment – and has dropped back to being small cap
  2. Small-Caps – as the name implies, are far smaller in terms of market valuation—but also, generally, scale, scope, and influence – market caps of $250 million to $2 billion
    1. But similar to Mid-caps – can span all business types, economic sectors, and growth phases – some small cap companies can be dominant in their market, but the market is just very small
    2. One common misconception about small-caps is that they are startups or brand-new companies. In reality, many small-cap companies can have well-established businesses with strong track records and great financials – and depending on the market that they are in, have a greater chance of additional growth beyond their large cap counterparts
  • Whilst small-cap shares have the opportunity to outperformed large-cap shares, it is not always the case – many small cap companies will have zero or negative returns over the long term
  1. Small-cap companies can be attractive due to their lower relative valuations and potential to grow – but this can be highly speculative
  2. This is because small-cap shares tend to be more volatile than their large cap counterparts – this is for a number of reasons – on of the major ones is a lack of justifiable financials for the market price versus their fair price valuations
    1. Think about ZIP – there was no real fair price valuation that could be conducted on the company, as there was no history of profits – only speculation around what this could be in the future – but the company is back to the same price it was a decade ago
    2. Another reason is due to the lower trading volume required to move their prices – I have discussed this in previous episodes – but if a companies market cap is $200m and the daily volume of trading is $20m, this could create a significant price movement in the company – compared to BHP at over $200bn, $20m wouldn’t move the price in either direction

What one is right for you – this really depends – not only on your own financial situation but also the investments

  1. As a quick summary, large cap companies are typically considered more stable and less risky because they are established and often pay dividends – Mid to Small cap companies are often considered as growth shares, offering the potential for high growth in the long term, but also carrying more risk
  2. Therefore, what you choose to invest in will depend on what you are looking for in a return profile – income or growth
    1. Large cap companies traditionally have a higher level of dividend yield compared to their small cap counterparts
    2. This will have some outliers – like CSL which is one of the largest companies on the ASX but only paying 0.88% in a dividend yield – compared to other blue chips like the banks that pay close to 5 to 6 % on average over the past decade
  3. But this does need to be broken down further – mainly due to diversification issues
    1. Anyone looking to invest in small cap shares and do so by cherry picking individual shares in this space should do so at great caution – risks of absolute losses are high
  4. This is where investing in the mid-to-small-cap space is often best done through either index funds or quality active managers – generally, the smaller the market cap, the better active managers can perform against the index

Lets look at the difference between the indexes performances to help explain this further

  1. ASX 50 – top 50 ASX listed companies, with BHP, CBA, CSL, NAB, WBC, etc
    1. The weighting to this index is 35% financials and 26% resources – so over 60% is between two industries – not the greatest from a diversification point of view
      1. PE – 14 – this is a general representation of the valuation of a company – as is expected
      2. Dividend yield 5% on average
  • Bu total returns – 1 year, 14.7%, 3 years 5.73%, 5 years 8.87% and 10 years 8.62% as at 31 Jan 2023
  1. Mid cap
    1. The weighting of this index become less top heavy compared to the ASX – 50 – 24% materials, 15% industrials, 10% financials, 105 energy, 9% TI, 9% Consumer discretionary, 9 % real estate, and the rest split between commutations, consumer stables, health care and utilities
      1. PE – 16.7 – higher than the ASX50 – where the price to earnings means that the are more growth companies – as expected
      2. Dividend yield 3.3% – almost 2% lower than the blue chips – also expected
  • Returns – 1 year 8.8%, 3 years 10.43%, 5 years 9.75% and 10 years 12.24% as at 31 Jan 2023
  1. Small Cap – the weighting of this index is the most diversified – materials make up the largest share at 25% and with a more equally weighted distribution that both the mid cap and ASX50
    1. PE – 17.5 – more growth orientated The cycle of the market has been a transition from growth companies, those within the small cap, to value companies –
    2. Dividend yield 3.2% – lower overall dividends
  • Returns – 1 year -4.4%, 3 years 2.41%, 5 years 4.35% and 10 years 5.37% as at 31 Jan 2023
  1. Looking at these indexes – the best returns have come from the mid cap over the long term – in the short term, the ASX50 has provided the better results – and this makes sense
    1. Due to market movements, in increasing interest rate environments, many growth companies can lag behind those companies not as reliant on debt to expand their operations
    2. What may surprise here, but also make complete sense is the small cap index having the worst performance out of the bunch – the general thought process is that this segment should provide better returns than the large cap shares in the long term – but on average this is not the case
      1. Think about the makeup of companies within the small cap index – some of these may perform very well, but many may not, or even decline in value – if you have 200 companies and 50 provide a great performance, 100 go nowhere and 50 lose significant values, then your returns will likely be poor
    3. The Mid cap index of 50 companies from Number 51 to 100 on the ASX are normally companies that have gone through their teething issues and have a better shot a future capital growth then say the 300th company on the index, which may yet to be tested in down markets – they have a higher chance of being picked up by investors and providing break out results, compared to the large cap which have already gone through growth spurts

What to choose – depends on your situation and your investment returns and needs

  1. As a general rule of thumb and based on the previous results, if you want dividends, especially FF dividends, the ASX 50 may be better suited for this
  2. If you are after the largest total returns – then the mid cap has historically been the place to be, albeit with a lower dividend income
  3. How to access – the ideal way as opposed to taking on additional absolute risk – by buying single holdings within each of these indexes – looking at buying the index itself – unless you are looking at the small to micro cap space – where the index has not held up well compared to its counterparts
  4. Once you start entering the territory of the small cap index, often best to opt for a high-quality active manager – one that has managed to outperform in all forms of markets, both up and down – This is important for a number of reasons – the most important is to have someone do the filtering of companies on your behalf on what is likely to be a good performer long term and what is not – remember, in the small cap index, there are 200 companies in Australia where each year, only a few have the potential to be breakout performers, whilst many can be underperformers
    1. I personally also like to play within the emerging companies index – also considered microcap – but my risk appetite can see 20 to 40% losses to see more on the upside – if you pay attention, then making additional investments in these down markets can see benefits – but this is not for everyone
    2. Some active managers in this space have been able to outperform all of the indexes
  5. But let assume that you have $10k to spare – over a 10 year period – assuming all the income is reinvested into purchasing more of this asset – excluding transaction costs and taxes, the following would be the results
    1. Large Cap at $22,861 – providing an income of $1,143 p.a.
    2. Mid Cap at $31,730 – providing an income of $1,047 p.a.
    3. Small cap at $16,872 – providing an income of $540 p.a.

Summary – What space to focus on in the share market depends on your needs –

  1. A focus on the large cap index may be suitable if you are after an additional FF dividend income source
  2. A focus on the mid cap index may be suitable if you are more concerned about total returns through capital growth
  3. A focus on the small cap index has historically underperformed – but this is where high quality active mangers with a proven track record of outperforming the market can come into their own – help to provide good long term capital growth returns
  4. If you can afford it, a combination of all can assist in further diversification – particularly if you aren’t reliant on the share market for an income return at this stage

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