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 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 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 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.
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.