Not all large caps are blue chips, but large caps are generally considered a less risky investment partly because of their stability and because they have a large float – more outstanding shares – which makes then more liquid than the smaller caps. Large caps also have much broader shareholder base and more significant research coverage.
The concept of the stable, established large cap was challenged during the Internet fever of 1999. New dot-com companies emerged almost overnight with market valuations in the upper half of large-cap stocks. But there was a significant difference. These newly minted large caps had low revenues and, in many cases, no earnings. The dot-com fallout separated the wheat from the chaff, so to speak. While many traditional large caps lost a great deal of their market value, the dot-com biggies fell 90 percent and more.
There are several indexes that track the performance of large caps. The Dow Jones Industrial Average DJI, which is the most common barometer of the market in general, is made up of 30 large-cap stocks from various industries. The broader S&P 500 SPX is virtually all large caps, and the S&P 100 OEX consists of the largest 100 companies of the S&P 500. The Russell Top 200 Index tracks large-cap stocks with an average market cap of $48 billion.
Mid caps is a relatively new classification, as we mentioned earlier. These stocks tend to have some of the stability of the large caps but also some of the high-growth prospects of the small caps. Mid caps also have institutional ownership but to a lesser extent than large caps do. Two former high-profile large caps, eBay and Yahoo!, had slipped into the mid-cap segment in the fall of 2001, demonstrating the fluidity of market-cap classifications. eBay was sitting on the cusp, with a market cap of $15.3 billion in early November, so by the time you read this, it may be back in large caps territory. Yahoo! has farther to go, with a current cap of $47 billion.
One of the most enduring characteristics of small-cap stock is their potential for rapid growth. After all, it is easier to double your market value if it is $100 million rather than $100 billion. Reward and risk however, usually go hand in hand, so it is not surprising that small caps tend toward more volatility and higher risk than larger caps do. One obvious reason for this is that the typical small-cap company has a single product line in a single market and is therefore more vulnerable. But small-cap aficionados will argue that a company with a single well-positioned product line can generate explosive earnings growth much more easily than can a company with hundreds of product lines in dozens of markets.
The shareholder base of small caps if often heavily weighted toward individual investors. Although there are many small-cap mutual funds, many institutional investors stock to large caps and mid caps. Further, many small cap companies have little or no research coverage.
A great majority of small caps are listed on Nasdaq simply because new and smaller companies find a more receptive environment on the Nasdaq than on the New York Stock Exchange. The New York Stock Exchange conducts its business through floor traders, and small companies can get lost without someone to support them and make a market in their stock, which is what the Nasdaq market makers do. Many small-cap stocks have four or five or even a dozen market makers who help them maintain visibility until they can make it on their own reputation. Nevertheless, there are small-cap stocks on the NYSE and AMEX, and large-cap stocks on Nasdaq.
One of the best-known benchmarks of small-cap performance is the Russell 2000 Index. It is made up of 2000 stocks with an average stock market cap of around $530 million as of fall 2001. Another small-cap index is the S&P 600, made up of 600 stocks with a mean market cap of $551 million.
Micro caps are the newest market-cap segment, although micro caps are not officially recognized as a separate cap by Russell, Morningstar, or S&P. This may be because micro caps have virtually no research coverage and little if any institutional shareholders. Institutional investors, who routinely invest millions of dollars in a single position, rarely invest in a company with a market valuation of less than $100 million. One reason is that an investment of just a few million dollars in such a company would entail an unacceptable level of ownership in the small company because it would imply control or influence. In addition, the lack of liquidity of a micro cap would be totally unacceptable since most micro caps trade fewer than 50,000 shares per day.
Nevertheless, it is likely that the micro-cap status will endure and eventually be commonly recognized. For one thing, a company with a market value of less than $100 million is very hard to compare to a company with a billion-dollar market cap – a twentyfold difference. So a separate category is needed to group these smaller stocks.
We should point out that the micro caps we’re talking about are the smallest stocks listed on New York Stock Exchange, the America Stock Exchange, and the Nasdaq – they are not the stocks that are “listed” on the so-called bulletin board or pink sheets.
Because of their size, micro-caps offer the greatest potential for reward and, not surprisingly, entail the greatest risk. Investor looking for huge returns may turn to micro caps for the next big winners, regardless of which market cap is currently in favor. Just keep in mind that patience is required to invest in micro caps. A micro-cap company needs to produce some solid growth to see its market valuation growth enough to place it in the small – or mid-cap sectors – and it can be years before such growth happens. Only then will the stock be likely to attract research coverage and, it is to be hoped, a steadily growing P/E multiple that can produce the tremendous price runs that excite any investor. In general, micro caps have not yet reached profitability, so their potential must often be measured in terms of revenue growth. Obviously, all these factors increase the risk.
As we said earlier, it is highly unlikely that micro caps will ever be the favored cap simply because of the lack of institutional ownership. The only index we know of for tracking micro caps is the Microcap 1000 Index. As of this writing, there are no ETFs for tracking micro caps.