Munger's own system of human psychology - Charlie Munger Investing Lessons by Equitymaster (2024)

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In this article we discuss basics of investing, understanding market capitalisation and allocation between large cap, mid cap and small cap stocks.

Differences between Large caps, Mid caps and Small caps

When understanding how to allocate funds for investing in equities, it is important to understand both your expectation of return (a function of your financial goals) and also your risk appetite. Once you are clear on these, it will be a lot easier for you to allocate money between the various categories of stocks.

In the first article, we understood the basic fact that investing is essential for achieving your financial goals. Now, let us step forward and understand the three categories one has to pick from for one's portfolio.

Understanding 'Market capitalisation'

There are three main classifications when it comes to stocks -

1. Large Cap stocks;
2. Mid Cap stocks; and
3. Small Cap stocks.

Here, the term 'cap' simply refers to the 'market capitalisation' of the stock.

And what is market capitalisation?

It is the value of the stock that you arrive at by multiplying the stock price by the company's outstanding number of equity shares.

Market Capitalisation = Current Stock Price x Number of Shares outstanding

For a better understanding, let us see an example:

Company XYZ has 10,000,000 shares outstanding and its current share price is Rs 8. Based on the above formula, we can calculate that Company XYZ's market capitalisation is Rs 80 million, or 10,000,000 shares x Rs 8 per share.

Large cap stocks

As we mentioned above, the first category based on market capitalisation is that of 'large cap stocks'.

One can look at the BSE-Sensex or BSE-100 Index as a reference point for large cap stocks. Market capitalisation for stocks in the BSE-100 Index, for instance, ranges from Rs 200 bn to Rs 3,500 bn.

These are stocks of usually large and well-established companies that have a strong market presence and are generally considered as safe investments. One important fact about large caps is that information regarding these companies is readily available in newspapers and magazines. Most of the large cap companies have good disclosures and therefore there is no dearth of information for an investor looking into them.

Large companies such as Infosys, TCS, and Wipro are classified as large cap stocks. These companies have been around in the industry long enough and have firmly established themselves as leading players. Their stocks are publicly traded and have large market capitalisations.

Mid cap stocks

Mid caps lie between large cap stocks and small cap stocks. Mid cap stocks are those that generally have a market capitalisation within the range of Rs 50 bn and Rs 200 bn. These represent mid-sized companies that are relatively more risky than large cap as investment options yet, they are not considered as risky as small cap companies. They rank between the two extremes on all the important parameters like size, revenues, employee and client base.

When one invests in mid caps for the long term, he may be investing in companies that could become tomorrow's runaway success stories. Generally speaking, mid cap stocks as an investment can bring you higher returns in 3 to 5 years as opposed to their big brother large cap stocks that can bring you moderate (yet safer) returns during this timeframe.

Small cap stocks

Lying at the lowest end of market capitalisation, Small cap stocks are generally viewed under the misconception of being hazardous or 'quick rich' stocks. However, both these labels are untrue.

Small cap companies have smaller revenue and client bases, and usually include the start-ups or companies in the early stage of development. Small cap stocks are potentially big gainers as they are yet to be discovered within the sector and can show growth potential in large numbers once unfurled in the market. However, as these enterprises are small ventures, these should be researched properly. This is considering that a lot of small companies do not have the financial strength to survive bad times and some of them might be mismanaged businesses run by greedy promoters. Hence it is essential, especially in the case of small caps investments that one does a thorough research regarding the promoters' credentials, management strength and track record, and long and short term growth plans of the company before investing.

Small caps are often stated to be a platform to make big returns in a short span of time. However, we would state that small caps can prove to be a very wise 'long term' investments especially if the chosen companies are good businesses and are well-managed.

Have a look at the table below to get a better idea about the return potential of small cap stocks over a 10 year period. Small cap wonders Change in share prices over the past 10 years

Now here's a table that clearly shows the differentiation between the three category of stocks we spoke of above - large caps, mid caps, and small caps. Key parameters for IT stocks across market caps

Conclusion

As seen from the above discussion, an investor has three options to choose from as far as allocating money to stocks is concerned. And the allocation is dependent entirely on an investor's risk appetite. All these categories consist of some really good long term investment opportunities. As such, investors must decide the allocation based on the opportunity's merit and not just whether it is a large cap, mid cap, or small cap.

But purely as a matter of prudence and safety, investors looking to build a portfolio from a 10 to 15 years perspective can have a 60-70% allocation to large caps and 10-15% each to mid and small caps. Treat this allocation as just a guideline and, we repeat, allocate your equity portion using your understanding of different kinds of companies across different levels of market capitalisation.

» Next: Setting the Foundation for Equity Allocation

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