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Market Cap Migration

02/14/2019

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This post will briefly discuss market cap migration, and explain the potential situations in which it could potentially place an investor.

What Exactly is Market Cap?

Market cap, or market capitalization, is the total amount of a company’s shares in dollars. The simple way to figure a company’s market cap would be to take the number of a company’s outstanding shares and multiply it by the company’s current price-per-share.

Market cap migration occurs when a particular stock crosses a set of asset classes, due to its growth. This fundamentally changes the nature of the stock. This change typically happens when a stock outgrows an index’s predetermined parameters.

Stocks are ordinarily divided into four or five categorizes based on a company’s total market cap. These categories generally include micro cap (under $250 million), small cap ($250 million-$2 billion), mid cap ($2-$10 billion), large cap ($10-$100 million), and mega cap (over $100 million).

Each category is subject to its own regulation and possess unique advantages and disadvantages. Bigger is not necessarily better for an investor, as you will read below.

What are Asset Classes?

Stocks within the same asset class show a number of the same characteristics, are similarly regulated, and can be expected to behave the same way.

The three primary asset classes are stocks or equities, bonds or assets tied to fixed income, and assets with cash equivalency. Each class has its own respective pros and cons, with higher yields often correlating with higher risks.

While it’s investment 101 to diversify your investments, when a person invests into a particular asset class, they expect the asset to show a particular set of characteristics.

For example, an investor would expect a bond to mature more slowly – while also being less volatile than the average stock.

Some stock investors are willing to accept a lower, steadier return on investment in exchange for reduced risk and more protection. However, market cap migration can complicate this.

There are additional asset classes such as real estate and items with precise value such as collectibles and artwork, but for the purposes of this article, the focus will be on equities.

The Pros and Cons of Various Asset Classes

Equities have been proven to outperform most other assets over a long-enough timeline. But with the greatest reward comes the greatest risk, as there is absolutely no guarantee of return on investment.

Stocks can also be extremely volatile in the short term, and the value of a stock can fall well-below what an investor paid for it. A stock’s value can crater and maintain at a depressed value for years, which won’t work for investors on shorter timelines.

Equities also offer no guarantees, unless an investor is collecting dividends. The value of a stock is almost completely dependent on a company’s financial performance.

Bonds have fixed rates of interest or maturity, and though the risk is mostly mitigated, there is also a ceiling to the earnings they can potentially generate.

Real estate is frequently considered to offer the highest risk and highest reward, and most seasoned investors only add real estate holdings to their portfolio for diversification and to protect against inflation.

Lastly, cash assets offer the lowest risk but also the lowest return, as they of course do not mature in most cases.

Analyzing Different Market Sectors

As explained above, stocks can evolve and migrate across different market sectors as their characteristics change. The stock market is divided into 11 sectors, which are then monitored on indexes such as the S&P 500.

Some of the U.S Sectors and Industries include energy, healthcare, utilities, consumer staples, information technology, and real estate. Each of these sectors generates revenue in unique ways.

For example, the financial sector generates the bulk of its revenue via loans and mortgages gaining value in conjunction with rising interest rates.

Meanwhile, healthcare stocks are considered to have large potential for growth, as the need for medical care and devices shows no signs of diminishing.

However, each sector is subject to its own laws, and can come with a specific set of challenges or even headaches.

Investors may grow comfortable with the laws and regulations of a certain sector (such as healthcare), but know nothing about a sector such as energy or IT. This complicates an investment, and may encourage an investor to divest an asset that has drastically evolved.

Finally, if a stock’s rising market cap causes it to enter another market sector entirely, this can place the investor in a financial situation far different than originally intended.

Problems and Solutions Stemming from Market Cap Migration

While in almost all cases an investor will be thrilled to see a given stock climb in value, problems do arise when a stock or asset migrates to an entirely-different market and fundamentally changes the way it’s regulated.

Market cap migration also means that the stock can be expected to perform in a different way than the investor originally intended. This can cause a high rate of turnover, which is often bad for a number of reasons.

Additionally, stocks can be coerced into markets in which they perform poorly, which is bad for the individual stock, the investors, and the market on the whole.

To combat problems stemming from migration, different groups and indexes have come up with different solutions.

The Center for Research in Security Prices ran a model in which they decreased the bandwidth of “breakpoints” between market cap categories. Using bigger bands between mega cap and large cap markets, while lowering the bandwidth between micro and small cap stocks, it was determined to be a promising solution to the turnover issue.

Another way in which the group dealt with market cap migration was to split a stock 50/50 between adjacent indexes and decline categorization until it showed a more stable pattern of behavior, demonstrating a dominant style or size.

In conclusion, market cap migration is much like the weather: it’s neither good nor bad, but simply something that occurs and must occasionally be dealt with.

In most cases, it’s a momentary destabilization, and more decisive action can be taken once a stock fully migrates into a new market cap category or market sector.

Linden Thomas & Company

One of America’s Top Wealth Managers builds a better Index

At Linden Thomas, we believe most indexes focus on the wrong things like weighting the index based on the size of a company (market cap).

We agree with many long-term academic studies that continue to validate the importance of how quality earnings are directly connected to real equity performance…

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