Investors put money in the equity asset class directly or through mutual funds. Typically, a systematic investment plan (SIP) route gets followed via the mutual fund way. Either way, the amount gets invested into shares of companies of varied sizes. The size of a company is determined basis it’s market capitalization. The investing community splits companies into three – small, medium and large-cap. Of course, each company has its characteristics, and there are pros and cons to investing in every company. Here, we will delve into understanding the benefits of investing in large-cap stocks.
Before we proceed, it is essential to understand a few key terms in this context.
What is total market capitalization?
The market cap (or market capitalization) is the total value of a company’s shares. One can derive it by multiplying the share price by the number of outstanding shares.
For instance, a company’s share price is Rs 50, and it has 10,00,000 total outstanding shares. So, in this case, the company’s total market capitalization will be Rs 50 X 10,00,000, or Rs 5 crores.
What is free-float market capitalization?
Primarily, there are two types of owners of any listed company – private and public. Privately held shares refer to the stocks which are not available for trading in the stock market—for instance, the shares owned by the promoters or those under a lock-in period, etc.
Free float gets calculated basis the outstanding number of shares held publicly. In other words, this is called free-float market capitalization.
Suppose the promoters held 55% of the total shares in the above example, and 5% were under a lock-in period. Therefore, 40% of the total outstanding shares are publicly available, or 4,00,000. The free-float market capitalization (also called float-adjusted capitalization), is Rs 50 X 4,00,000, or Rs 2 crores.
Why categorize companies based on their market capitalization?
A company should be valued basis the strength of the business and the vision of its management. It’s true, and of course, we all know this well.
However, it seems that just this is not enough. Why? Because the company’s size plays a significant role in its behaviour and prospects.
Therefore, investors need to understand the size of any company. Here is where the concept of market capitalization plays a key role. First, it allows investors to understand the size of the company. Secondly, it will enable investors to strategize investments to the correct bucket. Finally, and even more importantly, investors can compare companies relative to the other through market capitalization.
What is Market Capitalization?
The Securities and Exchange Board of India (SEBI) issued a circular on October 6, 2017. The subject was the categorization of mutual fund schemes. The circular defined the large, medium and small-cap to ensure uniformity in the investment universe.
Large-cap – top 100 companies in terms of the total market capitalization
Mid-cap – 101st to 250th company in terms of the total market capitalization
Small-cap – 251st company onwards in terms of the total market capitalization
As of December 2021, the total market capitalization of India was Rs 2.5 Lac crores. Of this, the large-cap shares represented approximately 70% of the total value.
Characteristics of companies based on their market capitalization
Every company is different, but two companies can be similar as well. Research shows that the traits any company shows can be broadly grouped based on their market capitalization (or size).
However, company behaviour is abstract and not cast in stone. These characteristics are determined basis historical information, but they can easily vary. For instance, a small-cap company can show traits of a large-cap or vice versa. Therefore, what we illustrate below is only indicative.
- Usually, these are young companies that serve niche markets or operate in emerging industries (or sub-segments within an established space)
- These companies are considered the riskiest amongst the three
- An economic slowdown or a downturn can severely impact smaller companies, given their limited financial resources and reserves
- Given their small size, small-cap companies are most vulnerable to competition
- Since these companies operate in niche markets and untested territories, they have the potential to offer significantly high returns
- Typically, the mid-cap segment represents a reasonably well-established set of companies
- These companies are in the process of making their mark and increasing their market share
- Through product innovation and technological advancements, these mid-sized companies gain their competitive edge
- Success in this stage determines whether the company will be able to operate for an extended period and achieve its full potential
- These companies have existed for a while, with tested products and established market space. Customers resonate with their brands, but they are also open to trying new products or services. Therefore, the risk is medium (higher than large-cap, but lower than small-cap)
- These companies are significantly big and typically have been in operations for (several) decades
- Large companies are the industry benchmarks in their offerings (products, services, quality, etc.)
- Their profitability is best in class, consistent, and they have a history of paying dividends
- The stock price has significantly grown over time. These companies have created tremendous shareholder value (through capital appreciation, bonuses, dividends, etc.)
- Due to the strong pedigree and solid historical performance, large-cap stocks often command a premium (read as high pricing multiple). As a result, large-cap stocks are usually quite expensive compared to other companies basis their earnings multiple, sales multiple, etc.
- The position these companies occupy in their sector is pretty dominant, and their name is synonymous with the industry they operate in
- Large companies have an abundance of resources and can easily withstand an economic downturn or adversity
- Given their significantly big size and high price, the returns they can offer is moderate
As you will understand, the market cap represents the stage of development of any company. Therefore, investments in large-cap stocks are considered conservative, and in small-cap are aggressive.
Large-cap companies have a dominant position and provide immense security to the capital invested. And, we will explore the advantages of investing in large-cap stocks.
What are the benefits of investing in large-cap stocks
The characteristics we mentioned above pretty much indicate the benefits. Here we categorically delve into every possible advantage of investing in large-cap stocks:
These companies are enormously large and are well-established in their sectors. Moreover, these companies have existed for many years, seen ups and downs, making them ideal for a long-term investment.
Given the stature, adverse economic circumstances or business down-turns may not significantly impact these large companies. However, that does not mean large-cap companies are immune to recession or down-turns. It is just that they have better means to withstand the slowdown.
In other words, it is not about the ability to avoid difficult situations. Of course, no company can avoid the impact altogether but trying times would never render them insolvent. Therefore, it is fair to assume that large companies have a far better capacity to resist any economic downturn and are highly stable.
Well researched and transparency of information
Most often, these companies have existed for (many) decades. As a result, investors, research analysts, and fund houses follow these companies’ businesses, products, operations, and management pretty consistently.
Therefore, it is easy to find most financial and non-financial details about these companies from the public domain. Further, the availability of required information allows investors to make well-informed decisions.
Consistent dividend payments
A dividend is a common way for corporations to distribute their profits to the shareholders. The share price for well-established large-cap companies usually grows moderately. However, these companies remunerate the shareholders with dividends.
Large companies are pretty consistent in their dividend payments, and they usually improve dividend per share each passing year. For investors, these dividend receipts act as are recurring cash inflows over and above the capital appreciation that continues to accrue with the increase in share price.
Large-cap stocks offer ample liquidity due to a high number of publicly traded shares. Therefore, it is usually relatively easy to sell or purchase any number of shares (from a retail investor’s perspective) from the market. Further, a significant unravelling in a retail investor’s portfolio will not adversely affect the stock price.
The growth and progress of a company depend a lot on the quality of its management team. Typically, the promoters, board, senior management of large companies are veterans of their field and have significant experience.
Performance in sync with the economy
The large-cap companies (often called blue-chip companies) form a large portion of the total market capitalization of India. As of December 2021, the total market capitalization of India was Rs 2.5 Lac crores. Of this, the large-cap shares represented approximately 70% of the total.
In other words, the performance of large-cap stocks generally represents and is synonymous with the country’s overall economic health.
A rising economy will usually translate into an optimistic forecast for the large-cap stock performance (as a group). But, of course, there will always be sector-specific variances.
While there are significant benefits of investing in large-cap stocks, please note that:
- Large-cap companies come at a premium valuation
- Limited price appreciation (returns) despite growing market
- The total number of large-cap stocks are a handful in number (one hundred after the release of the SEBI categorization circular)
What aspects should investors consider?
We have deliberated on large-cap stocks’ characteristics and delved into the benefits of investing in large-cap stocks. But, of course, this does not mean that investors should only concentrate on this segment. However, if you would like to invest in large-cap stocks, here is the summary of factors to consider:
Risk: large-cap stocks are subject to market risks, like any equity investment. However, the risk is moderate compared to other equities, and price volatility is less. Therefore, these stocks can be a good option for investors willing to take some risk and participate in the equities asset class.
Returns: investors can expect decent yields when they partake in low to moderate risks. However, the returns from these stocks are pretty stable and consistent over time.
Investment horizon: like any equity investment, these stocks are suitable for investors with a long-term investment horizon. Of course, there can be intermittent troughs and peaks, but investors must never get affected.
Create corpus: large-cap stocks are suitable for investors who want to build a large corpus with low to moderate risk. Another essential factor is consistency when investors are creating the corpus. Therefore, investors must have patience during the investment horizon.
Taxes: any income from the sale of shares (including the large-cap shares) is subject to income taxes. Investors must plan for the impact of taxes before taking a decision.
What are the possible alternatives:
- Upcoming mid-cap stocks based on their recent growth
- Index funds or exchange-traded funds (ETFs) that mimic the index performance, not requiring investors to invest in every company individually
- Well-researched multi-bagger stocks, currently classified as other than large-cap
The final thoughts
In conclusion, investors must take investment decisions considering their goals and risk appetite.
In a nutshell, there are two ways to participate in equities – direct equity purchase or investment via a mutual fund. Both investing methods, direct or through mutual funds, are acceptable. However, we recommend the mutual fund route for beginners and investors who do not track the financial markets closely. Read here to find out more about which is better between direct share purchase or mutual funds.
Above all, the decision to invest in large-cap or otherwise must be well-calibrated. Accordingly, we have listed characteristics, advantages, and essential aspects to consider before investing in this category of equity shares.
We sincerely hope this note will help you make up your mind and help you make the right decision. But, of course, you must take external assistance and engage with a financial advisor in case of any unanswered questions about the investment process and choices.
Happy investing in large-cap equities!
About the author
The author is a senior finance professional with over fifteen years of work experience in corporate finance. He has an affinity for matters relating to personal finance and investment management. The author wants to share his knowledge and understanding of the subject through his writing.
The author has used his knowledge, experience, and understanding of the subject and has exercised extreme caution to avoid possible mistakes. However, the author does not take responsibility for any error that exists.
The article’s views, opinions, and thoughts belong solely to the author and not necessarily to the author’s employer (past or current), organization, committee, or other group or individual.
Under any circumstances, the author shall not be liable for any views or analysis expressed in this note. Further, the opinions expressed are not binding on any authority or Court. We advise readers to consult their financial advisor for assistance in their specific case.