Markets & Strategies

Understanding Large-Cap Stocks and Small-Cap Stocks

What investors need to know for keeping an optimal mix in their portfolios.

by Suzanne Bopp - August 14, 2017

It seems simple: Large-cap stocks are shares of large companies, and small-cap stocks are shares of smaller companies. But there is much more to know — and those nuances are important to investors seeking to maintain a diversified and balanced portfolio.

Behind the definitions

What are large companies and small companies, and who decides? Investment professionals agree on and communicate specific definitions to pair with their recommendations.

“For us — and this changes as the market moves up and down — a large-cap company would have market capitalization of $12.5 billion or greater,” says Scott Wren, Senior Global Equity Strategist at Wells Fargo Investment Institute. “Small cap means $3 billion or less.” As the market moves up and down and the valuations of the overall market also move, those numbers change.

The definitions are in-house decisions made by the investment strategy committees at Wells Fargo. They reevaluate the definitions every six months or so — though they make changes only sometimes. “You need to see a meaningful change in the market for those numbers to change,” Wren says.

Additional differences between large-cap stocks and small-cap stocks

A major distinction between large-cap stocks and small-cap stocks is in terms of their companies’ international exposure; large-cap companies typically have quite a bit. “For instance, in the S&P 500®, around 35% of their revenues come from overseas,” Wren says. “Small-cap stocks indexes typically have little to no international exposure.”

As the [economic] cycle wears on and growth rates typically slow down, people tend to focus on the large-cap stocks.

Large-cap stocks tend to be shares of companies that have many products sold at home and abroad. “Small-cap stocks tend to be more of a one-trick pony; [small-cap companies] have far fewer products, maybe just one product, that they’re selling domestically,” Wren says. “Large-cap [companies] typically have easier access to credit because they have stronger balance sheets, which can support doing things like buying back shares. Small-cap [companies] typically have less ability to do that.”

Small-cap companies also typically have less diverse revenue streams; they are almost completely, if not completely, tied to the ebb and flow of the U.S. economy. Large-cap companies, on the other hand, can take advantage of not only the U.S. economy, but also movement of the global economy because of their international exposure.

“Right now, there’s some pick-up in the global economy, whereas in the United States, there’s not as much,” Wren says. “There are some good opportunities abroad; large-cap stocks have more opportunity to participate in that.”

Trends in large-cap stocks and small-cap stocks

The current state of the economic cycle can play a role in performance of small-cap stocks and large-cap stocks.

“We’re in the 7th inning of this cycle, to use a baseball analogy; there’s still some baseball to be played, but it’s getting toward the end of the game,” Wren says. “That’s typically the part of the cycle where large-cap stocks have tended to outperform and small-cap stocks have underperformed.”

Small-cap outperformance has typically happened early in a cycle, as the market emerges from a recession and people see better times ahead. They’re willing to take on more risks then, Wren says, and some of that risk can be taking a chance on smaller companies.

“The U.S. usually comes out of a recession ahead of the international economy, and so people tend to buy domestic small-cap stocks then, and that’s what happened in this cycle,” Wren says. The first few years of it, small-cap stocks may outperform, but then as the cycle wears on and growth rates typically slow down, people tend to focus on the large-cap stocks.

A diversified investment strategy includes exposure to both large- and small-cap stocks, Wren says, but the amount may vary depending on where we are in the economic cycle — so it may be prudent to be nimble and consider adjusting accordingly.

Suzanne Bopp has written for Salon.com and Utne Reader.

Image created from iStock

Additional Resources

More diversification strategies:

RISKS:

All investing involves risks including the possible loss of principal. Equity securities are subject to market risk which means their value may fluctuate in response to general economic and market conditions and the perception of individual issuers. Investments in equity securities are generally more volatile than other types of securities. The prices of small-cap company stocks are generally more volatile than large company stocks. They often involve higher risks because smaller companies may lack the management expertise, financial resources, product diversification and competitive strengths to endure adverse economic conditions.

Investing in foreign securities presents certain risks not associated with domestic investments, such as currency fluctuation, political and economic instability, and different accounting standards. This may result in greater share price volatility. These risks are heightened in emerging markets.

Diversification cannot eliminate the risk of fluctuating prices and uncertain returns. Diversification does not guarantee profit or protect against loss in declining markets.

Wells Fargo Investment Institute, Inc. is a registered investment adviser and wholly-owned subsidiary of Wells Fargo Bank, N.A., a bank affiliate of Wells Fargo & Company.

Opinions represent WFII’s opinion as of the date of this report and are for general information purposes only and are not intended to predict or guarantee the future performance of any individual security, market sector or the markets generally. WFII does not undertake to advise you of any change in its opinions or the information contained in this report.

Wells Fargo & Company affiliates may issue reports or have opinions that are inconsistent with, and reach different conclusions from, this report.

The information contained herein constitutes general information and is not directed to, designed for, or individually tailored to, any particular investor or potential investor. This report is not intended to be a client-specific suitability analysis or recommendation, an offer to participate in any investment, or a recommendation to buy, hold or sell securities. Do not use this report as the sole basis for investment decisions. Do not select an asset class or investment product based on performance alone. Consider all relevant information, including your existing portfolio, investment objectives, risk tolerance, liquidity needs and investment time horizon.