Investing with different caps

Everybody's raising a toast to the new lifetime highs for the Sensex and the Nifty... but are you wondering why your portfolio has not matched the stellar returns on these indices. A closer look at the kind of companies that make up your portfolio may give you the answer.

Stocks of small and mid-sized companies have lagged behind well-known names by a big margin over the last one year. While the Nifty (which represents a basket of large-cap companies) has recorded a 44 per cent gain over the past year, the CNX Midcap index (which represents mid-cap companies) has managed only 28 per cent.

Large-, mid- and small-cap stocks perform differently through different market phases. This is why paying closer attention to the market cap profile of the stocks you buy could help you achieve much better investment results.

Market cap boundaries

Market capitalisation or "market cap" is a simple indicator of the value placed on a company by the market at today's prices. It is arrived at by multiplying the number of outstanding shares of the company with its current stock price. Stocks are classified into large, mid or small cap, based on their overall market cap. Bellwether indices such as the BSE Sensex and the CNX Nifty represent a basket of large-cap stocks. At present, the market cap of stocks in the Nifty basket range from Rs 5,000 crore to Rs 1,86,000 crore, with the average market cap at Rs 39,000 crore. Under present market conditions, stocks with a market cap of over Rs 5,000 crore are usually considered as large cap stocks, while those between Rs 1,500 and Rs 5,000 crore are considered as mid-cap stocks; those falling below the Rs 1,500 crore bracket would be classified as small caps.

However, the boundaries between large-cap, mid- and small-cap stocks are not carved in stone; they change in tune with market conditions. What was a small-cap stock a few years earlier may graduate to a large-cap status, as the company ramps up in size and gains greater recognition from the market?

How they differ on risk and reward

Just as the risk-reward equation for a steel stock is vastly different from that for a technology stock, large-cap stocks offer a return potential different from mid- or small-cap stocks. As large-cap stocks usually represent well-known companies with a sizeable scale of operations, they often carry the potential for steady growth in line with the economy.

Earnings of such companies will seldom grow in leaps and bounds, but may exhibit fewer surprises from quarter-to-quarter or year-to-year, as they are tracked by a veritable army of analysts!

Foreign institutional investors (FIIs) seeking to dip their toes into the Indian markets often make their first investments in large-cap stocks. If you are the conservative type, do not plan to actively manage your portfolio and would like to buy and hold for the long term, you should probably pick your investments from the basket of large-cap stocks.

On the other hand, if you like a big dose of excitement with your stock market investments and are hoping for multi-baggers, you must sift through multitudes of mid- and small-cap stocks to home-in on your choices. Mid- and small-cap stocks usually represent companies that are in nascent businesses or those that are lower in the pecking order, within a sector, in terms of revenues or market share.

Though they offer potential for higher returns because of their ability to register earnings growth at a faster pace, mid- and small-cap stocks often carry higher risks. Their earnings could suffer bigger blips because of vulnerability to a downturn in the business. Also, small and mid-cap stocks are often not traded as actively as large caps, dwindling volumes could magnify the decline in prices of such stocks in the event of a market meltdown. It is, therefore, important to put your choice through a liquidity filter (check for the stock's historical trading volumes over a couple of years) before investing in mid- or small-cap stocks.

Different boom-bust cycles

Because of their differing risk-reward characteristics, large-, mid- and small- cap stocks usually have distinct boom-bust cycles within a broader market trend. Large-caps are usually the first to lead any market recovery, while mid- and small-cap stocks tend to join in later.

If you are booking profits on your portfolio because you expect a big correction, your mid- and small-cap stocks should probably go first, as they would be most vulnerable to any meltdown in prices. Mid- and small-cap stocks will usually under-perform large caps during periods of high uncertainty.

Global events impacting FII flows or political upheavals often prompt a "flight to safety" which results in liquidity fleeing mid- and small-cap stocks into the tried-and-tested large-caps.

In the Indian context, mid-caps/small-cap stocks sharply outpaced large caps in the year to May 2006; but bore the brunt of the correction in May/June as investors reacted to the spike in global oil prices and the prospect of a US slowdown.

However, the experience of the past five years suggests that large-, mid- and small-cap stocks do not always follow the textbook scenario; therefore, making your decisions on the basis of individual stock valuations and your own appetite for risk, is quite important.

If you now have a grip on how large-, mid- and small-cap stocks behave, here are a few additional pointers on investing based on market cap:

Maintaining a balance between large-, mid- and small-cap stocks in your portfolio is as important as spreading your investments across different sectors and businesses. Making investments only in small and mid-cap stocks could make for high volatility while sticking only with the large-caps could deliver modest results.

Though shifting your allocations between large-, mid- and small-cap stocks based on market conditions promises the best results, practicing such a strategy can be quite difficult, requiring timing skills. A much easier approach would be to decide on your allocations to each group based on your appetite for risk and to adhere to this, irrespective of market conditions.

Investing the core portion of your portfolio in a flexi-cap fund (equity funds which have the flexibility to change allocations between market caps) with a good long-term record, would be a good way to make sure that you leave the call on allocations to an expert.