Why to diversify portfolio based on market capitalization

Building and maintaining a thoughtful asset allocation is among the most essential elements for long-term investment success. The goal of diversification is not necessarily to boost performance as it doesn’t ensure gains. For individual stock holdings, investors should be cautious of overconcentration in a single stock and it’s better to diversify across stocks by factors such as market capitalization (small, mid, and large caps), sectors, and geography. Again, not all caps and sectors may perform well at the same time and to the same extent, but individuals will be able to reduce portfolio risk by investing across various segments of the market when done with a considerate approach.

How do the risks of large cap stocks differ from the risks of small cap stocks?

Market capitalization is a key element in achieving proper diversification in an investment portfolio precisely because there are distinct levels of risk between large- and small-cap stocks. Depending on the individual risk profiles and their tolerance for downside risks, if the portfolio is adequately diversified the investors will be able to manage any unexpected eventualities.  Although small-cap stocks are considered riskier investments than large-cap stocks, there are enough small-cap stocks which offer admirable growth and returns for the conservative investors.

What factors make investors help build an appetite for small cap stocks?
 

• Ø  One main aspect is that, it is easier for small companies to generate proportionately large growth rates than mature companies, and historically many small-cap stocks have outperformed the large-caps. Also, smaller companies, often run by a small, closely-knitted managerial staff, can quickly adapt to changing market conditions. Moreover, the management in the small-cap space is ambitious and shows promise.
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• Ø  Investing in small-cap stocks allows investors to buy promising companies at an early stage in their growth cycle and can fetch potentially higher returns because some of these companies can scale up from a low base and grow into large-caps. Historically, it is witnessed that some small caps (which keep on building on great prospects and financials) turn into a multi-bagger investment opportunities.
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• Ø  Another advantage in investing in small-cap stocks is the potential for discovering unknown value. Small-cap companies are not as well researched as large-cap companies by analysts. Small-cap companies are not in limelight, and therefore lay down a greater potential for undervalued opportunities.
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• Ø  Sometimes, lack of market liquidity in small-cap stocks provides benefit when large numbers of buyers suddenly seek to buy a less liquid stock and drives up the price more than large cap liquid stocks.
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• Ø  Merger and acquisition activity also provides an opportunity for small-cap investors. Large companies can enter new markets or by acquiring smaller businesses. Acquisitive companies usually pay a premium to market price to acquire small cap growing firms and gaining intellectual property rights leads to share price appreciation.
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But some Food for thought before you invest bluntly in small cap stocks
 

• Ø  Small-cap stocks don't have high trading volumes and have a lower trading liquidity. So, trading/exiting sometimes becomes difficult, especially in adverse market conditions as it is difficult to sell shares quickly at favorable prices.
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• Ø  From business point of view, comparing to large-cap companies, small-cap firms generally have less access to capital and it makes difficult for smaller companies to obtain necessary financing to fund new growth opportunities especially during economic downturns.
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• Ø  Another risk with small-cap stocks is a lack of operational history and the potential for business models to survive. Small companies are not as likely to have an established, loyal customer base and are more vulnerable to consumer preference changes based on established brands. Many small- and micro-cap companies look attractive from business view but may not be able to professionalize and reach to the next level.
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• Ø  Another risk prevails around small-cap companies’ corporate governance and transparency. Not much information about small companies is commonly available to the public, and this makes informed evaluation of small-cap stocks more difficult for potential investors.
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However, it is prudent to note that things sometimes go well along with market investment trends. For instance, the February earnings season was a mixed one but many investors were seen to shrug off from smaller and riskier companies. One example has been Yowie Group that lost about 22% in last six months owing to a weaker than expected result but is again gaining momentum with recent marketing updates and performance improvement (up 17% in last one month).

Why large cap stocks also become an important area to lay your hands on?
 

• Ø  Large cap businesses are generally stable and many of them pay dividends based on their earnings. Further, large-caps are widely considered to be an appropriate core holding in any investment portfolio.
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• Ø  Large-caps are less likely to witness big downturns occasionally experienced by smaller companies. Of course, the large-caps may not see the great returns that the small-caps sometimes achieve.
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• Ø  Institutional investors, like pension funds, mutual funds and insurance companies favor tend to favor large-caps in order to have a widespread institutional investment to keep their prices stable.
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• Ø  When the economic/market outlook is gloomy, sticking with large-cap stocks is beneficial to avoid liquidity-related issues with supporting matured/stable revenues and cash flows.
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However, large-cap companies are dominant in traditional businesses; and by investing in large-caps, it becomes difficult to get exposure in new business areas. Sometimes, investments looked for gains over a shorter period may also not sync well with large cap stocks.

For example, Scentre yields around 4.8 per cent franked about 27%, but offers limited growth only (in fact the stock has slipped about 1.5% in last one year). Similarly, Telstra which is witnessing a lot of negative sentiments these days has slipped 11.6% in last six months. On the other hand, BHP Billiton (fully franked annual yield of 2.8%) has swung back in action driven by commodity price rebound in late 2016 (up 53.5% in last one year).

All in all, a balanced portfolio supported by thoughtful analysis of the interplay of economic factors, market sentiments and a company’s financials and product pipeline, becomes the key to lead the investment race.
S&P AUST ASX SMALL ORD Index against S&P AUST ASX 200 Index (Source: Financial Times)

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