Market Cap And Returns: What To Bet On

Market capitalisation of a stock is defined as the market price of the stock multiplied by the number of outstanding shares, also called as full float. It is primary indicator of the size and is widely used by stock exchanges to calculate values of indices using market capitalisation as weights.

BSE follows the 80-15-5 rule to classify companies based on their free float market capitalisation. This is carried out by arranging all the listed companies in descending order of their market capitalisation. From the top the first group that contributes together 80% of total market capitalisation is classified as ‘Large-Cap Stocks.’ The next set of companies that together contribute 15% of total market capitalisation is classified as ‘Mid-Cap Stocks.’ The remaining lot that together contribute 5% of market capital is classified as ‘Small-Cap.’ In this study we have used the full market capitalisation and applied the 80-15-5 rule.

Risk levels of investing in the three buckets differ, for a small company it is possible to grow sales at a rate of 25% whereas for a big company it is difficult to grow sales and earnings organically at high rates.  Since value comes from the future cash flows of the company, which is a function of the growth in a company, the share price of a small company can increase manifold when things go right but can also destroy value if things go wrong. On the other extreme, investing in large cap stocks is relatively safer as there is a consistency in track record, consistency in financial performance, high quality of audit work and a broad base of shareholders which protects the share price from high volatility. Mid-caps are largely shares with a mix of risk and return.

We select 1000 companies based on market capitalisation as on  September 29, 2016. We calculate returns from share price appreciations and classify them in three buckets: First bucket comprises of large cap stock where the company’s market capitalisation is more than Rs 12,587 crore. Second bucket of mid-cap stocks have companies where market capitalisation is in the range of Rs 2,047 crore to Rs 12,586 crore. Last bucket comprise of small-cap stocks where market capitalisation ranges from Rs 300 to Rs 2,000 crore.

Returns are calculated based on prices as on September 29 of every year from 2012 to 2016. The CAGR is calculated for each stock and separated into three buckets for analysis. 

Average returns calculated in table-1 indicate that small-cap and mid-cap returns are generally higher than large cap returns. Since averages are influenced by extreme values, we also obtained median values indicated in Table-2.

Table-2 indicates the median return within each bucket and we can see the median returns within each bucket are not very different for returns in year one, two and four. Now let’s include risk as a measure to see if these three portfolios differ from each other. We use standard deviation as a measure to calculate risk using the annualized CAGR values.

Table-3 indicates the standard deviation of each portfolio. Higher number would indicate a higher risk. As can be seen, risk is lowest when we invest in large-cap stocks verses mid-cap and small-cap. If we compare standard deviation for one year horizon for large cap it is 0.35, whereas for small-cap it is 0.86.This proves that lower the risk, lower the returns and vice-versa. We have analysed the companies in the risk-return framework. Now let’s analyse which of these three portfolios had more number of companies creating or destroying values.

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We define value destroyers as companies which generated returns less than zero percentage. After obtaining the number of companies which created or destroyed values, we divided the number with the total number of companies within each bucket to obtain percentage of companies creating or destroying value.

* Percentage of companies within the portfolio, generating returns less than 0%

Chart-1 indicates the number of companies in each portfolio which generated returns lower than 0%. Over the three and four year horizon, the smallest bar indicating 9% (3-yr) and 12% (4-yr) is of large cap stocks which suggest that within the large cap stocks we have the lowest number of companies destroying value. Maximum numbers of companies destroying value are in the small cap bucket between 2 to 4 year returns.

Just as there are companies which destroy wealth, there are companies that generate wealth. We assumed a rate of 15% as cut-off rate to calculate how many companies earned more than 15% CAGR.

* Percentage of companies within the portfolio generating returns in excess of 15%

Chart-2 indicates that when the horizon is four year in the large cap bucket, we have almost 58% companies earning returns in excess of 15%. When we analyse one year returns across all the three buckets, we have ~51% companies earning in excess of 15%. This makes a strong case that in the long run, large cap stocks create more wealth as compared to mid-cap and small cap stocks.

If you wish to earn abnormal returns, then you can focus on small cap stocks, but keep in mind that there will higher risk involved and higher percentage of companies would destroy value. When trying to select stocks within the small-cap universe, retail investors have to be more accurate in analysing the companies.