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Friday, September 06, 2013

What are Large, Mid and Small Cap Funds


We keep hearing terms like large-cap, small-cap and wonder what type of stocks we should own and what these terms really mean? How does someone calculate whether a company is a large-cap or mid-cap? With so many people having such questions in mind, i thought of sharing this post with you.


What is Market Capitalization?
If you wish to buy a company and all its shares were offered to you at the current market price, how much would the company cost you? The answer is its Market Capitalization. Yes, you will have to pay the “Market Capitalization” of the company which is the product of a company’s total number of shares outstanding and the market price of the share.

Example
Let’s understand it with the help of an example. Suppose, you decided to purchase ABC Industries, when its shares were trading at Rs.50 and the number of  shares outstanding were 1 Crore. You would have paid,
Rs.50     x    1,00,00,000    =    Rs. 50,00,00,000
i.e., Rs. 50 Cr. is the Market Capitalization of ABC Industries.

What does Market Capitalization reflect?
However, what you should remember is that the market price of a share is the public opinion about the worth of a company’s stock. Thus, Market Capitalization is the public opinion of what the whole company is worth. This opinion is based on the past performance, future prospects and market sentiments of the public about the company. The market capitalization changes with time as a result of factors like company performance, economic factors like inflation, interest rates, etc.

Categorization of Companies
In India, you can find companies with market capitalization ranging from a few lakh to as much as few lakh Crores ! As a result, companies are usually classified as large-cap, mid-cap and small-cap companies.

What are Large-cap, mid-cap and small-cap companies?
We have frequently heard about some companies being Large-cap (e.g. Reliance, Tatas, Infosys etc.), while many others being Mid cap or Small-cap companies.  "Cap" is short for capitalization, and generally used for market capitalisation. Wonder how they are classified? Let’s take a look at how the BSE classifies companies according to their market capitalization.

The 80-15-5 method
BSE uses a method called as the 80-15-5 method. Here’s how this method works:
  • Arrange all the companies in descending order of their Market Capitalization.
  • The group of companies from the top, which together contribute 80% of the total Market Capitalization are Large-cap Companies,
  • The next group of companies contributing 15% (80-95%) of Market capitalization are Mid-cap companies, and
  • The remaining companies which contribute 5% of Market Capitalization are Small-cap companies.

Thus, the Large-cap companies, Mid-cap companies and Small-cap companies contribute 80%, 15% and 5% of the total Market Capitalization of the market respectively. This is known as the 80-15-5 method. The number of small-cap companies is the highest followed by mid-cap and large-cap companies. Thus, a small proportion of the total number of companies (large-cap) contribute the major part (80%) of total market capitalization.

Thumb Rule
As a thumb rule, the market capitalization of small-cap companies is up to two thousand crore, mid-cap companies is between two thousand to ten thousand crore and large-cap companies is above ten thousand crores. However, this does not mean that if the market falls or rises considerably, large-cap companies will become mid-cap and mid-cap will become small-cap, or vice versa.

Rather, the above ranges will change with a change in Total Market Capitalization.

What is the significance of Market capitalization?
It is regarded as an indicator of a company’s size. Large-cap companies are more robust. A large-cap company can be compared to a heavy goods carrier, while a mid-cap company to a mini carrier. If there is a speed breaker/bump on the road, the chances of a mini carrier getting knocked down are much more as compared to the heavy goods carrier. At the same time, a mini carrier picks up speed quickly and travels faster as compared to the heavy goods carrier; which requires time to catch up speed but has better stability and momentum. 

Summary
So, when you build your equity portion of the portfolio,  make sure that you have a core foundation of large cap companies, and over and above that, you can buy a limited set of mid or small cap companies to balance your risk-reward ratio.


All the best !!

Cheers



Manoj Arora
Lead a Financially Free Life !!

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