Investing Basics Stocks – Categories, Capital Structure and Theory Behind Outperformance

This is a continuation of the last post discussing basic financial principles as it applies to individual stocks. Read Part 1 first if you haven’t already

There are many ways to describe a stock/business, but the 3 major categories are: the market cap size, the sector and geographic location.

Market Capitalization

Market cap size refers to the overall quoted value of the stock.

Market Cap = the stock’s trading price X the total number of outstanding shares of the company.

For example as of today Apple’s Market Cap = $168 share price X ~ 5 billion shares   = ~$855 Billion valuation.

Common definitions relating to market cap size (as I’m doing this I realize how dated these relative sizes will be to teaching my kids in 15 years!)

Mega Cap = >$300 billion valuation. Think Apple, Google, Berkshire Hathaway, Amazon.

Large Cap = >$10 billion valuation. Think most well established businesses .

Mid Cap -$2-$10 Billion

Small Cap – $300 million – $2 billion

Micro Cap – $50 million – $300 million

Nano Cap – <$50 million

The general market view is that smaller cap companies will have higher potential risks because they are not established players in their competitive landscape and face more business uncertainty. This coincides with potentially higher reward if the company can create a new niche or grow quickly.

Mega Cap companies tend to dominate the major indices and typically hold the #1 or #2 competitive position within their industry. This creates potentially more stable profits, but also typically limits the high growth potential of these companies.

Typically smaller cap companies are less followed by major indices, mutual funds or ETF’s. This is because a large institutional asset manager with $1 billion AUM (assets under management) will have a tough time investing in $500 million market cap companies. This is for two reasons:

a) Small cap stocks are typically illiquid (meaning very few shares trade on the exchange on any given day). This means a large buyer needs to buy in small increments over weeks to months and it will be equally hard to exit the position.

b) At $1 billion AUM, a $100 million investment represents 1% of total assets. For a $500 million company, they need to buy 20% of the whole company to barely allocate any capital! Often investment managers have limitations on buying stocks that are outside of major indices and can not exceed certain thresholds of % ownership.

This leads small cap companies to typically be less efficient than mega caps which I will explain further in the discussion about active vs passive investing.

Sector

Sector is fairly easy to understand as it correlates to the type of industry the business operates in. Examples would be technology, health care/pharmaceutical, consumer staples or consumer discretionary, energy, real estate etc.

Any given sector may have wide aberrations in performance for prolonged periods of time. The mining and oil/gas sectors are notorious for going through highly volatile cyclical periods. Other boring industries like consumer staples (think toothpaste and toilet paper) tend to have very stable profits.

Geographic Location

Geographic location is often broadly broken down into Canadian, US, European, or International stocks. When a company obtains revenue primarily from a single geographic region, there is risk if that economy has a recession or political instability.

When dealing with mega-cap companies, geographic risk becomes less of a concern. Many of the major companies in the SP 500 (US stock market) receive profits from many countries throughout the world.

The importance of these categories will factor in when discussing asset allocation strategies. As a general rule, establishing a mix of these different categories leads to a form of diversification within a stock portfolio. Diversification can lead to less volatility than if a portfolio were concentrated in one sector, market cap size or geographic location.

Capital Structure of a Stock/Business

It is important to notice the difference between ownership of a company’s stock/equity and a corporate bond from the same company. The debt interest of the bond will always be paid out first to a debt holder from the company’s cash flow before the stock owner can receive any benefit from this cash flow. If the company can’t achieve either its interest or principal debt repayment, it can be pushed into bankruptcy as discussed in the linked bond post. This happens due to the capital structure of ownership in business.

The stock holder has less right to a company’s assets compared to a bond holder, but benefits much more when the company enjoys success and profitability. A fancy way of wording this is that equity in a business is subordinate to all other forms within the capital structure of the business as shown in the diagram. The equity will receive its portion of a business last in the event of a bankruptcy.

Why Do Stocks Outperform Other Asset Classes?

The post discussing Stocks For the Long Run showed the empiric evidence of stocks significantly outperforming other assets in the long run. My intellectually curiosity always pulls me to ask the reason why. The increased risk within the capital structure is only taken by the stock holder when that individual thinks there is a reasonable chance of a better overall investment return than the bondholder. The fancy financial theory term for this is called the risk premium.

This idea of expected risk/return is a tenet of Modern Portfolio Theory which is an academic theory to help explain why stocks achieve better overall long term returns than bonds. It is believed that higher return only comes with increased risk. Hence the general belief that stocks are the “riskiest” asset class. I believe this is only part of the story though.

Assets that have an ability to adjust for inflation on a real time basis should inherently have an advantage. Bonds typically start with an interest yield and remain at that amount until the contract duration ends. I just finished watching the Berkshire Hathaway AGM where Warren Buffet mentioned you really need to focus with a long term perspective on what assets will produce the best inflation adjusted returns.

Businesses that have pricing power can often adjust their prices in real time to the increased costs of goods and services around them. As long as their remains demand for its products and services, the business can maintain a similar profitability scale. A  good business that is well run also has flexibility in what it chooses to do with profits to optimize financial circumstances based on the current environment.

Conversely, a business that can’t adjust its pricing runs the risk of losing profitability and becoming bankrupt. It may seem that the major profitable companies in the world are untouchable, but the creative destruction of the free market economy spares no one. We tend to think of Apple, Google and Amazon as untouchable in today’s economy, but 50 years ago people would have said the same thing about Sears and Kodak. Almost no company has stayed at the top of market cap size over the last 10 years and half of the profitable companies from 50 years ago have disappeared! Just look at some of the sample chart below.

Final Thoughts

 

I believe there is a significant advantage when owning major stock market indices for the long term instead of other asset classes. The key is to believe in the pricing power over inflation on aggregate of the businesses within major indices. Recessions, wars and economic panic will ensue dozens of times during your investment life but faith in stocks will reward you. Individual businesses will fail, but economies will keep adapting and producing further societal benefit and productivity moving forward. A solid, diversified stock portfolio is hard to beat! I could go on for days about stocks, but this covers the basic concepts and definitions. Hopefully these posts will help frame the discussion around stock markets moving forward.

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8 comments On Investing Basics Stocks – Categories, Capital Structure and Theory Behind Outperformance

  • Hello FFMD!

    I heard about you from Dr. Networth and Loonie Doc. You are as obsessive about taxes as LD is. Well it is a wonderful service you guys provide. Congrats on your young family!

  • Hi FFMD!
    Congrats on the young family. Busy times for sure, but definitely worth it. My kids are 12 and 10 now which is loads of fun. They are old enough to do cool stuff with and young enough to still think I am cool enough to do it with. The golden age. Great article. I have leaned more towards stocks given the better long term returns also. The one caution that I have with that approach is that people need to behaviourly be able to stick with it through volatility which is hard. A fixed income component may give up some returns, but improve them overall if they help to enable better investor behaviour by smoothing the ride and soothing the emotions. I am still torn on it a bit personally.
    -LD

    • Hi LD

      I totally agree the #1 priority is only take on the equity exposure that you know you can handle behaviorally. 1 mistake behaviorally can wipe out a significant portion of net worth.

      I was pretty explicit in my risk tolerance post about why I feel comfort with my risk tolerance and dont recommend it to most others.

      Having said that, I do think if you handled 2008-9 with ease and acted behaviorally correct it may mean you could handle more equity if you know your timeframe is still long.

      Im 35 and have 20+ years for my assets to grow. I will consider dropping my equity exposure in about 10 years, but will stiĺl keep it higher then most!

  • Hi Dr MB

    Great to see some other Canadian doctor bloggers out there! I checked out your site quickly and like your writing style!

    I hope to engage in some great discussion with you all as time goes on. I can tell there are a few things where I personally diverge from classic personal finance teaching that will create some good discussion!

  • Hello FFMD & LD!

    I am guessing that you and your wife are family docs. You guys are young and do not require a job. You are who can handle 100% equities if that’s how you roll. My only worry for you is one of your posts said your wife was not happy when you lost certain bets in the past. That is my situation. I have zero issue with emotional investing but my husband does. Therefore, I need to take that into account.

    If the markets have a prolonged drawdown- just go work some already. That’s what I’d do. Zero risk indeed. Plus there are two of you. If one doesn’t feel like it. hopefully the other one will.

    My greater concern are when I see some bloggers have jobs and then they tap out at some arbitrary number. Good grief! When I reached FI in 2004, I never gave up my license. What the heck for? I just wanted to spend some more time with my kids. Now after a dozen years working just enough to keep my license active, I am looking forward to working more. We certainly do not need the money but medicine is still pretty awesome in Canada.

  • Dr MB

    You really nailed it on the head that my personal circumstances allow me to take on more volatility than most.

    My wife is quite ok with our approach because she knows we plan to work part time even in Financial Independence. The large nest egg really acts as a sense of comfort to allow flexibility in your choices. The number is just an abstract concept until you truly Retire Early amd need to make sure the funds will last.

    I really enjoy medicine about 80% of the time and the other 20% headache can be administrative/hospital politics stuff. The fact that we are still working during FI creates a significant hedge against market downturns.

    I have read opinions about MD’s who retire early should feel guilty for not giving back to their profession. I don’t buy that argument because life has so many unknown variables and you only get one shot. But I do think it is a very stimulating profession and allows for socializing with intelligent people as well.

    I view my medicine career as a slow steady jog where I will target 20-25 hrs a week factoring in that my job requires 5-7 days of shift week and then a week or so off ( my wife and I are both hospitalists)

    I figure this should stave off burnout etc and keep me interested enough for a while. Only if a really exciting opportunity to explore something new would make me consider a hiatus from medicine in the near future.

    Thanks for your thoughts!

    FFMD

    • Your plan sounds absolutely perfect. That was our plan until my husband decided he wanted to specialize. The issue with owing to the profession is bunk. We will all work to some extent because few of us will be handed millions for nothing.

      I worked 6-7 days a week for almost a decade early in my career and saved most of it. I took two week maternity leaves when I had my children. But all this has allowed me to work about 1 day a week for the past dozen years. It’s been quite lovely.

      Have you figured out the plan with all the tax changes with the CCPC? Do you still plan to withdraw dividends yearly for living expenses? How about salaries to contribute to the CPP?

      I plan on holding some ETF’s within the CCPC. It would be helpful to see what you invest in and in which entity.

      I am very open with my investment plans. The whole point of this blogging is to have others let me know if they see my plan running into a brick wall. And to learn other options potentially.

      • Hey Dr.MB & FFMD,

        It is pretty cool to see the portfolio thoughts with the three of us at slightly different stages. I am 42. I was 100% equity until this past year and will likely shift some of that to have some fixed income over the next 2-3 years, but still fairly aggressive until I am getting close to being done. You are smart to have figured out career pacing that early on FFMD – I have been a slower learner on that one. Putting my portfolio structure on my blog is in my plans also – I am just figuring out some re-jigging with the new CCPC rules because they do affect me. I read about your portfolio Dr. MB on your recent post and liked it – simple, efficient, and well diversified. I totally agree that our biggest super-power fiancially as docs is actually not investing (I just hope to avoid mistakes), but rather the ability to make money well, control our spending enough to save/invest it, and to minimize the tax/fee bite where possible.
        -LD

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