Large-Cap and Small-Cap Stocks: What You Should Know

This article was supposed to be a reminder that, during tough times, it’s generally better to hold large-cap stocks than small-cap stocks. We’ll get into the theory in a moment but, like everything else that once made sense, the coronavirus pandemic has completely contorted that dictum beyond recognition.

There is no appreciable, risk-adjusted difference at this moment between large-caps and small-cap stock indices. Between the March 23 market bottom and August 4, the Dow Jones Industrial Average index representing large-caps bounced up 42%, while the Russell 2000 small-caps rebounded by 50%. Of course, the smaller the company the greater the risk, other things being equal, so it’s not surprising that the volatility index associated with the large-caps dropped farther than the volatility index associated with the small-caps: 61% versus 52%.

The rule that proves the exception for stocks

Although the definitions of “small-cap” are a little vague, it’s generally agreed that a large-cap has a market value in excess of $10 billion – although, now that there are several companies worth more than $1 trillion, perhaps that ought to be upwardly revised. These big companies are exemplified by the 30 stocks that comprise the Dow Jones Industrial Average.

While Fidelity sets the small-cap range of $300 million to $2 billion, that’s not the most practical answer. The most widely recognized small-cap index, the Russell 2000, has components with values recently measured as low as $94.8 million and as high as $4.4 billion.

Large-caps, the thinking goes, had to stand the test of time to grow that big. They tend to be stable with diversified products and markets, and thus less volatile during economic downturns. They also are more likely to pay dividends, suggesting that there’s a guaranteed income from these stocks.

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Large-caps are more likely to pay dividends; small-caps typically don’t pay dividends

Small caps, on the other hand, are more growth-oriented. They may be executing on just one or two good ideas and, as markets become volatile, these securities – which typically trade without dividends – become ill-suited to risk-averse investors.

This accepted wisdom, though, is starting to fray at the seams. Of the 30 blue chips in the Dow, four – Cisco Systems, Home Depot, Microsoft, and Apple – are roughly the same age as the mid-career brokers selling them. Four others pay no dividend, according to Dividend.com, and four pay dividends with yields of 1% or lower. So maybe we’re just talking about the deep and shallow ends of the same pool; as long as you’re staying afloat, there’s no real difference.

Buyers be where?

Even so, the conventional wisdom exhorts that the larger the market cap, the greater the liquidity. While that might make intuitive sense, intuition is not the plural of “datum.”

The real issue is how we measure “liquidity.” These come down to:

  • How fast you can sell your shares without moving the market;
  • The transaction cost of the trade; and
  • The size of the bid/ask spread.

But let’s bring it down to the scale of the typical retail investor. Any stock in the Russell 2000 might be small compared to Microsoft or Visa, but it’s still probably a billion-dollar-plus enterprise. And the fact that it is listed in any index at all suggests that there are funds that are chartered to own some proportion of it. Would you even be aware of the difference in execution time of selling a hundred shares of Amazon versus that of a hundred shares of BJ’s Wholesale Clubs?

As for the fee per trade, there’s a wide range depending on how you execute. On-line trades can range from free to $20, ValuePenguin reports, and broker-assisted trades run anywhere from $20 to $55 depending on the brokerage and the services provided. Over time, these fees keep trending down.

As for bid-ask spreads – the amount by which the price you’re asking for your shares exceeds the price a potential buyer is willing to pay for it – a few years ago, the U.S. Securities and Exchange Commission examined how this affects the market for small-cap stocks.

“In 2013, more than 41% of small capitalization stocks (with a market capitalization less than $1 Billion and the price at least $2) had to mean daily quoted spreads of 4.5 cents or less,” according to the September 2014 report. “Nearly one-third of these (or 14% of the total sample of small-cap stocks) had to mean daily quoted spreads of 1.5 cents or less. On the other side of the spectrum, 25% had to mean daily quoted spreads of 15 cents or more.”

So, the best small-caps have roughly the same bid-ask play as typical large-caps. The worst ones don’t. But it’s hardly gouging, and it’s not as if you couldn’t get out of your position at any price. If you’re desperate to get out of a hundred shares, you’ll probably pay 15 bucks for the privilege and smile.

How times change

Once upon a time, there was a difference in how large-caps and small-caps performed. In 1974, Wilshire Associates first started splitting stocks into indices based on market capitalization and proved without a shadow of a doubt that, over time … small-caps beat large caps! It wasn’t until 1990 that large-caps caught up but, by 1999, the biggest companies were seeing the biggest gains. It was the Great Recession which turned that around, and that undermines the whole buy-big-stocks-during-downturns thesis.

The fact that it keeps rebounding while the rest of the economy lags also defies earthly constraints.

“If every other Financials [sector] industry is down double-digits year-to-date, why is Capital Markets treading water?” AlphaSense observes. “It can only be that securities prices are untethered to what the retail banks, credit card issuers, business lenders, and insurers are seeing.”

Clearly, though, there’s going to be some debate about whether it’s better to buy large-caps or small-caps at this moment, just as there’s going to be a discussion about whether we’re currently in a bull or a bear market. Conventional wisdom, right or wrong, drives a lot of market behavior and can even become a self-fulfilling prophecy. Maybe it’s best to consult a financial advisor.

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