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Market Cap Vs. Factor

02/12/2019

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Many investors do not fully understand the difference between market cap and factor-based indexes. This article will help explain some of the differences between the two, as well as examine some of the pros and cons of each. Read on to learn more.

Determining Portfolio Weight

Before fully unpacking market cap and factor, it’s first important to understand portfolio weight and its role within finance and investment. Portfolio weight is simply the percentage that a particular equity or holding has within an investment portfolio. The weight of a given asset can be calculated by measuring the asset’s dollar value versus total holdings, or in the case of equities measuring the units of a particular stock versus the total shares held in the portfolio.

You may have a diverse portfolio that includes holdings such as REIT investments or even collectibles. For the purposes of this article, the primary focus will be on stock holdings, as those are most directly affected by changes in market cap and factor. Once portfolio weight is considered, the next move would be to identify which markets or sectors you would want to enter as an investor, and then which companies or projects within those markets make the most investment sense. After you’ve decided exactly what you want to invest in, you would then decide the amounts you would want to invest in each respective stock or project. This is where market cap comes into play.

Understanding Market Cap

Market cap, or market capitalization, is a term you will frequently hear in finance and investment. This section will briefly review market cap, and better explain why it’s so important to monitor. The concept is so critical to understand because it helps investors distinguish between companies of different size, at which point investors can invest more strategically and effectively.
Market cap is simply a company’s total net worth, factoring future projects as well as the company’s overall perception and reputation. All of this ultimately determines the value of an equity or share.

A company’s market cap is calculated by multiplying the stock price by the total number of outstanding shares. For example, a company with 100,000 outstanding shares trading at a price of $12.50 per share would have a market cap of $1,250,000.

Small-Cap Companies

A company of this size would be considered a nano-cap company. This is the smallest market cap classification per most definitions. Small-cap companies are generally divided into nano-cap (total cap under $50 million) and micro-cap ($50 million to $2 billion in total capitalization) categories. Stocks with market capitalization under $2 billion are generally considered to be small-cap stocks.

Mid-Cap and Mega-Cap Companies

Moving up, other companies can be classified as mid-cap ($2 billion to $10 billion), large-cap (over $10 billion), and mega-cap. The threshold for mega-cap companies fluctuates, but these are huge companies with market capitalization often exceeding $200-$300 billion.

Examples of mega-cap companies would include Amazon, Facebook, and Walmart, all of which could be considered blue-chip stocks. These companies can be expensive to buy into, but an investor is almost assured of a significant return on investment.

Which Comes with Higher Risk?

The rule of thumb is that a lower market cap comes with higher risk. Micro-cap companies are growing and less-established, and investors assume a lot of risks buying into micro-cap companies. Because small-cap (and especially nano-cap) companies are inexpensive and offer potentially-high rewards, they are frequently the subject of speculation. Whereas larger companies are generally easier to project (and thus offer more stable stock prices), small-cap companies tend to be extremely volatile, for a number of reasons.

Micro-cap companies sometimes lack the capital to follow through with their business plans, and are frequently at risk to be assimilated by a larger company or go out of business altogether. These are significant concerns to any potential investor. The upside is that small-cap companies can potentially yield exceptional returns on investment, if you happen to invest heavily in a winner. This is where market analysis becomes less of a hard science and more of a gamble.

Market Cap Indexes vs Factor-Based Indexes

With a full understanding of market capitalization, you can better understand which other factors to consider when determining portfolio weight and which stocks to invest in. Next, stock indexes are frequently weighted in different ways. Two of the more common ways in which indexes are weighed are by market cap and, more recently, factor indexes have emerged. Factor-based indexes have been created to stem some of the top-heavy problems seen in price-weighted indexes. These indexes account for different variables that drive equity returns aside from sheer dollar amounts or total market cap.

Below are some of the pros and cons associated with both market cap weighting and factor-based weighting:

Market Cap Weighting

The advantages and disadvantages of market cap weighting are addressed above. Smaller-cap stock are typically easier and less-expensive to obtain, but come with a number of inherent risks. One advantage of capitalization-weighted indexes is that they typically incorporate a float factor or adjustment that takes publicly-available shares into account. Shares that are “closely held” are controlled by government or insiders, and are not readily available for trade.

A cap-weighted index that also incorporates a float factor to account for closely-held shares is in most ways an accurate way to gauge a given market. However, it may not account for specific factors that may mean more to particular investors.

Factor-Based Weighting

Rather than simply assessing a stock based on company size, a newer way in which investors measure stock value is by considering alternate factors that drive up equity. Some of the different factors that investors can weigh and consider include annual earnings, book value dividends, liquidity, and the number of employees in a given company. Most factors are company-specific, and an investor who prioritizes cash flow, for instance, could target or buy into more-liquid companies with lower total market capitalization. This would be one way to locate a high-return anomaly with a given market. Investors can also use this model to assess stock-specific risk, such as lack of dividends or low book value, and diversify their portfolio accordingly.
This is another strength of the factor-based model.

Interpreting Market Cap vs Factor

While there is no perfect system for determining a stock’s worth, market cap and factor-based index weighting have proven to be two of the more reliable, contemporary ways of determining and projecting a stock’s value. Factor-based investing is simply a different way of constructing a portfolio, and may offer sharp investors an advantage over more traditional models such as using market cap alone to interpret the value of an equity.

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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