Small Cap Definition
Small businesses with low value of market capitalisation are categorised as ‘Small Cap’ firms. A firm’s outstanding shares in the market make up its market capitalisation value. Firms with market capitalisation values ranging from $300 million to $2 billion are called as ‘Small Cap’ firms, but this is by no way a strictly defined range.
A Little More on What is a Small Cap Firm
The Securities and Exchange Commission (SEC) forbids mutual funds from scooping up all the outstanding shares of a Small Cap firm, allowing individual investors to beat institutional investors in acquiring substantial stakes in a Small Cap firm. A mutual funds management would have to file a petition with the SEC to acquire substantial stakes in a Small Cap firm, revealing its hand in the market and driving up share prices.
Different brokerages and markets have different measures to categorise Small Cap, Mid Cap, and Large Cap firms. There are no set rules to categorise a firm as either one or other and the range and definition keeps changing.
Calculating Market Capitalization
Multiplying a firm’s total number of outstanding shares with the current share price gives its market capitalization value. For e.g., Sonic Corp had 48.55 million outstanding shares in June 2016. It’s stocks were trading at a per share value of $28.16. Multiplying the two values gives us the total market value of Sonic Corp as $1.37 billion. Based on this number, most brokerage firms would categorise Sonic Corp as a ‘Small Cap’ firm.
Investing in Small Cap vs. Large Cap Companies
While Small Cap firms offer investors high growth potential, this potential comes at very high risks. Large Cap firms have usually tided over their Small Cap days and although they do not offer exponential growth, they provide stability to investors.
Economic trends demonstrate that Small Cap firms outperform Large Cap firms by huge margins in terms of providing returns on investments. But this is speculative and trends vary with changing economic scenarios. For e.g., during the tech boom of the 1990s, Large Cap firms dominated the conversation and capital flow. Post the recession in the early aughts, Small Cap firms enjoyed a much higher degree of success than their Large Cap counterparts.
Investors should focus on other more important factors before betting on a firm and also diversify their portfolios with shares in both Small and Large Cap firms, to make the most of the benefits offered by firms in both categories.
References for Small Cap
Academic Research on Small Cap
Investor sentiment and stock returns, Fisher, K. L., & Statman, M. (2000). Financial Analysts Journal, 56(2), 16-23. This paper examines the diverse sentiments between stock holders, investors, wall street punters, and journalists following stock markets, and their influence on stock returns.
Growth versus value and large-cap versus small–cap stocks in international markets, Bauman, W. S., Conover, C. M., & Miller, R. E. (1998). Financial Analysts Journal, 54(2), 75-89. This paper uses four valuation ratios to determine the true growth value of Small Cap firms vis-a-vis Large Cap firms in international markets.
The value premium for small–capitalization stocks, Dhatt, M. S., Kim, Y. H., & Mukherji, S. (1999). Financial Analysts Journal, 55(5), 60-68. This paper examines data from the United States small cap index, also known as the Russell 2000 Index, to evaluate value premium for Small Cap stocks.
Are Euro area small cap stocks an asset class? Evidence from mean‐variance spanning tests, Petrella, G. (2005). European Financial Management, 11(2), 229-253. This study uses mathematical models and regression based tests to examine the effectiveness of investing in Euro small cap stocks.
New technology and the small firm, Jovanovic, B. (2001). Small Business Economics, 16(1), 53-56. This paper examines the role of Small Cap firms in light of the changing economic scenario, especially in light of current technological advancements.
New paradigms in stock market indexing, Jun, D., & Malkiel, B. G. (2008). European Financial Management, 14(1), 118-126. This paper focuses on the paradigms of Indexing practices in Stock markets and the factors that influence the categorisation of firms under different market caps.
International diversification with large-and small–cap stocks, Eun, C. S., Huang, W., & Lai, S. (2008). Journal of Financial and Quantitative Analysis, 43(2), 489-524. This paper examines the diversification of portfolios in international markets with both small and large cap stocks investments.
The temporal relationship between large‐and small‐capitalization stock returns: Evidence from the UK, Grieb, T., & Reyes, M. G. (2002). Review of Financial Economics, 11(2), 109-118. This paper examines the relationship between small and large cap firms with data from the United Kingdom stock markets.
Examining market efficiency for large-and small–capitalization of TOPIX and FTSE stock indices, Hung, J. C., Lee, Y. H., & Pai, T. Y. (2009). Applied financial economics, 19(9), 735-744. This paper studies the market efficiency of small and large cap stocks with data from Tokyo and London stock exchanges.
Corporate environmental policy and abnormal stock price returns: an empirical investigation, Thomas, A. (2001). Business strategy and the Environment, 10(3), 125-134. This paper studies the correlation between companies adopting environmental protocols and excessive stock market returns by examining empirical data.