Diversifying by Company Size

Another consideration in diversifying your portfolio is the level of market capitalization (market cap). This is a popular comparative measurement, representing the value of a corporation's net worth (assets minus liabilities). Net worth primarily consists of the value of capital stock and retained earnings. Market capitalization is the sum of all outstanding common shares, multiplied by the current market price per share. So when stock prices rise, so does market cap; and when market price falls, so does market cap. The distinctions are made among companies not so much due to daily price fluctuations, but in broader terms.

The three primary categories in terms of market cap are large cap ($10 billion or more of equity value), mid-cap (between $2 and $10 billion), and small cap (less than $2 billion). Additional distinctions are made by some to include mega-cap, or companies whose net worth is greater than $200 billion; and micro-cap, including companies with equity value between $50 million and $300 million. These distinctions are important because they provide an important method for diversifying beyond simply buying different stocks. The big-cap companies are often the strongest in terms of market domination. These companies also tend to fit the definition of blue-chip companies, those paying dividends even in soft markets, with stable and growing earnings and little or no long-term liabilities. In selecting large-cap stocks, you opt for safety, but at times this may also mean lower-than-average volatility. Such companies at times, but not always, may move more slowly than the average company in the market. On the other end of the spectrum, small-cap stocks tend to be much more speculative because they are young and do not have a track record. However, those that succeed may do so with dramatic price appreciation. It's important to remember that every large-cap stock started out as a small-cap stock. Market capitalization as a factor in diversifying is easily overlooked but can be one of the most important ways to spread risk. It's similar to buying real estate. Where do you buy? How much are houses worth? Is the neighborhood on the rise or on the decline? Are high-priced homes appreciating faster or slower than average-priced or low-priced homes? Anyone who tracks the real estate market understands quite well how the price range of homes defines market trends. The same is true for stocks.

Key Point

Large, well-capitalized companies tend to be safer. They may also tend not to offer as much profit potential. Picking the right long-term investments is a balancing act.
A method of diversification may be to spread capital among the three major classifications (large cap, mid-cap, and small cap) to expose yourself to potential price appreciation while also having a portion of the portfolio in safer companies with a longer track record. The market is huge, and you will have no problem finding companies in any of the classifications. The total value of all publicly traded companies is about $40 to $50 trillion (Reuters, March 21, 2007; and Federation of Exchanges, www.world-exchanges.org).

Key Point

How much is a trillion? This amount is impossible to imagine. But some perspective helps. A stack of $100 bills adding up to $1 million is about five feet high. A stack equal to $1 billion is one mile. And a stack equal to $1 trillion is 10 miles high.
Diversifying by market cap is one of many ways to spread risk. An alternative to market cap is enterprise value (EV), which is a measurement of the entire business, including both equity and debt capitalization. Market cap is based on valuation of common stock alone; EV adds preferred stock as well as all long-term debt. You can also diversify in terms of liquidation risk, meaning buying some preferred shares to create an ultra-safe position for a part of your portfolio. You may also diversify by buying some domestic and some foreign stocks. Today, with the global online availability of trading, it is easier than ever to invest around the world. Many specialized funds also specialize by country or region. You can also diversify by investing in U.S. companies with a large share of income derived from overseas. Well-known examples include Johnson & Johnson (JNJ), Coca-Cola (KO), and McDonalds (MCD), among many others.
By Michael C. Thomsett
Michael Thomsett is a British-born American author who has written over 75 books covering investing, business and real estate topics.

Copyrighted 2020. Content published with author's permission.

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