The Indian equity market comprises 6000-odd stocks listed on the Bombay Stock Exchange and/or the National Stock Exchange.
Given this large number, it becomes necessary to categorise them so that some sort of meaningful analysis is possible. Depending on one's requirement, this categorisation could be done in many ways - industry-wise, turnover based, market capital etc.
Market capitalisation (referred to as market-cap in general parlance) is one of the common methods of classification. It represents the value of the company as perceived by the stock market and also indicates its liquidity in the market. Technically, it is defined as under:
Market cap = Number of shares issued by the company, multiplied by the market price of the share.
However, considering the fact the promoters' usually do not trade in the market with their quota of shares, the above definition could give a wrong picture about the tradability of the company's stock.
For example, the market cap as per the above definition may work out quite high. But, if say 85 per cent of the stock is held by the promoter and hence not available for day-to-day trading, the effective tradability of the stock will be quite low.
Hence, a modified definition is generally adopted, viz:
Market cap = No. of free shares in the market (i.e. the floating stock), multiplied by the market price of the share.
Based on the above definition, companies are generally classified as large-cap, if the market cap exceeds Rs 5000 crores (Rs 50 billion), mid-cap for market-cap between Rs 1000-5000 crores (Rs 10-50 billion) and small-cap if the market cap is below Rs 1000 crores (Rs 10 billion).
This break-up, however, is not any given standard and hence may vary from person to person and also from time to time.
Looking at the market-cap, one can at a glance get a feel about the company's market perception, risk and liquidity, before one makes a deeper research into other quantitative and qualitative factors. Further, a sector-wise analysis of market-cap movements can indicate the hot sectors and the not-so-hot ones.
Small-cap companies
These would generally be start-up companies or those, which are small in their business size.
The economic environment today is of rapid change. This gives the small companies, who are generally nimble-footed, to take advantage of new business opportunities. Being usually a one-man show the decision-making would comparatively be much faster than the large companies.
However, being small, their business model may usually not be robust enough to withstand any adverse changes in their industry. They may also be hampered by lack of resources and professional management.
From the stock market perspective, the low equity capital makes such stocks susceptible to large price movements even when relatively small quantities are bought or sold. They, therefore, tend to be highly volatile.
Given this scenario, the risk of both upside and downside is quite high. Therefore, such stocks are usually recommended only for the very-aggressive investors who are knowledgeable enough and have very high risk-appetite. Also, such stocks are relatively illiquid and hence one could experience difficulty in buying and selling.
Another important point, though a bit unfortunate one is that such stocks with low floating stock are manipulated by certain unscrupulous operators to make a quick buck at the cost of naïve investors. So, extra caution is recommended when investing in such stocks.
Large-cap companies
At the other end of the spectrum, we have large well-established businesses.
Such companies have strong businesses and can be expected to deliver steady returns without any shocks.
But, being large, the growth potential is limited. They may already be enjoying a large market share and hence growing further may not be an easy proposition. New opportunities may take time to be captured as the decision-making process moves through various levels in the company.
Further, with a large floating stock, even large deals of buy/sell may not move their prices significantly. They are, therefore, less volatile.
Such companies, therefore, are suitable for risk-averse passive investors, who want to make steady income with low risk. They are a good long-term bet. Large-cap companies would usually deliver broad market-returns.
Mid-caps
As the name suggests, they fall between the large-caps and the small-caps. They have grown but still have potential to grow further vis-à-vis the large-caps. On the other hand, the business risk has come down vis-à-vis the small-caps.
Such companies therefore suit a moderately aggressive investor looking for something better than the market-returns and willing to take somewhat higher levels of risk as compared to the passive investors.
They form a very important part of an investor's portfolio, to provide boost to the returns with a relatively moderate risk levels. India is a growing economy and has the potential to remain so for next 10-20 years.
This offers immense opportunities for small and mid-cap companies to grow and create wealth for themselves and for the investors. Of course, there will be lot of failures also on the way, which means one has to tread with caution.
A balance amongst various caps suiting to one's risk appetite will help maximise the risk-reward ratio.
The author, Sanjay Matai, is an investment advisor. He can be reached at sanjay.matai@moneycontrol.com
