When we buy a stock, first and foremost we are buying a stake in a business. Of course, there are many other factors that come into play when we buy or invest in a particular stock.
How well a business is growing, what sector it operates in and what the competitive outlook in its industry looks like are just some of the considerations.
Perhaps one of the biggest, in my opinion, that isn’t really thought about is the market capitalisation (also known as “market cap”) of the stock you’re buying.
But what is market cap? It’s pretty simple. Effectively, it’s the value of all outstanding shares multiplied by the price of a stock.
So, why is it important? Here’s what investors should know about how market cap plays into long-term investment considerations.
Understanding market cap mechanics
The biggest companies in the world have the largest market caps. Prominent examples include Apple Inc (NASDAQ: AAPL), Microsoft Corporation (NASDAQ: MSFT) and Amazon.com Inc (NASDAQ: AMZN), which all have market caps well above US$1 trillion.
It’s widely recognised that all of the above stocks could be considered “core” and relatively “safe” holdings in any portfolio given the amount of cash they generate and the profits they produce.
As a result, the volatility of these so-called “mega-cap” tech giants is likely to be much less than the volatility you would see with many of the tech names that might be found in Cathie Wood’s ARK Innovation ETF (NYSE: ARKK), for example.
Yet, in a sense, for Apple to double in value would be difficult. That’s because the iPhone producer has a market cap of over US$2 trillion.
For it to become a US$4 trillion company would mean an extra US$2 trillion in value being created. That’s an extremely unlikely feat – at least in the next decade or two.
Age and market cap
For younger investors, then, that means identifying fast-growing companies that have smaller market caps which can then (hopefully) grow into the Amazons and Apples of tomorrow.
That doesn’t mean younger investors shouldn’t own these mega-cap tech companies or other big companies (they are fantastic businesses) but the longer-term return potential from these types of stocks are likely to be limited when compared to smaller companies.
Take the video conferencing provider Zoom Video Communications Inc (NASDAQ: ZM). Its share price skyrocketed by nearly 400% in 2020 and even after that its market cap was still just below US$100 billion (so one-twentieth the size of Apple).
Small cap versus large cap
Overall, numerous studies have shown that smaller companies tend to outperform larger companies over the longer term.
That does not mean that larger companies’ share price performance is negative over the long run. It just means that smaller companies have shown to deliver superior positive returns over longer time horizons.
Lastly, it’s key that younger investors are invested in the right smaller companies to ensure this long-term outperformance.
So, the next time you take a look at a company’s potential to grow into a juggernaut, the market cap can be one way to gauge its future runway for expansion – in both its business and share price.
Disclaimer: ProsperUs Head of Content Tim Phillips owns shares of Microsoft Corporation.