The SmallCap Informer focuses on small company stocks, this much is true. However, the definition of “small” is not as easily determined as it might at first appear. There are a number of methods that are used by various data providers, educational organizations, and market indexes to identify small-cap stocks, and just as many different actual definitions.
There are three primary ways of determining the size of a public company. The first, and perhaps the most common, is by the market capitalization of the company, determined by multiplying the number of shares of stock that are outstanding by the price of those shares of stock.
One problem with measuring company size using market cap is that it incorporates a large measure of investor sentiment into the calculation. Companies that are liked by investors will have higher market caps than companies that are unloved (all other things being equal).
For instance, the list of the largest companies in the U.S. and Canada ranked by capitalization includes Twitter Inc. (TWTR) at around position #350. With a market cap of $24.0 billion, one could assume that this company is a big, established operation that’s making plenty of money for shareholders. In reality, Twitter had revenues of $665 million in fiscal 2013 and lost money to the tune of $1.79 per share.
Yes, Twitter is an emerging business, and yes, it has significant “mind share” in the social media space, but the company has not yet figured out how to build an ongoing enterprise. Some investors are obviously betting that the company will start making money in the not-so-distant future, driving up the valuation of the business.
But when compared by market cap, Twitter’s next closest peer, just up one position on the list cited above, is a pretty well-known global business called Sony Corp. (SNE), which has a market cap of $24.2 billion and 2013 sales of $77.5 billion. Yes, Sony hasn’t been a “growth stock” in a decade, and yes, Sony also lost money in 2013 in the neighborhood of $1.2 billion, but the Twitter/Sony comparison illustrates the problem with market cap. Companies are pegged by a value that doesn’t tell investors whether a company might be in the ascendency or in the descendancy.
Move another twenty or so places down the list of largest companies and you’ll find Dollar General (DG) with a market cap of $21.2 billion. Unlike Twitter and Sony, Dollar General actually makes money consistently; on 2013 sales of $14.5 billion, the company earned $1.0 billion in net income, or $3.17 a share for stockholders. By market cap, though, the company is valued lower than the value of Sony or Twitter.
For all the negatives of using market capitalization as a method of defining company size, it’s the de facto standard on Wall Street, perhaps because it’s an easy number to calculate, but perhaps as well because Wall Street doesn’t care much about fundamentals, so measuring a company by its popularity is good enough for them.
The generally accepted definition of company size by capitalization is that small-cap stocks have market caps below $2 billion. (Companies currently tracked by the SmallCap Informer max out at a market cap of about $2.5 billion.)
Large-cap stocks have market caps above $10 billion, with mid-caps falling in between small and large. Micro-caps have market caps between $50 million and $300 million, with nano-caps coming in below $50 million. On the other end of the scale, mega-caps have market caps above $200 billion. (A reminder: these definitions are general in nature and are frequently modified by mutual funds, indexes, financial advisors, and data services according to their own methodologies.)
If you look at companies in the Russell 2000 stock market index, however, you’ll see companies that have much higher market caps than $2.0 billion. This is because the Russell 2000 Index includes the smallest 2000 companies of the 3000 largest companies in the US markets. You might need to read that sentence twice to grasp its full meaning; the Russell 2000 does not include the 2000 smallest companies in the U.S., or even the 2000 smallest according to some fixed definition.
This method of determining stocks for the Russell 2000 Index is why Russell’s definition “small-cap stocks” is actually growing over time. According to The Royce Funds, in 1995 the largest company in the Russell 2000 Index had a market cap of $750 million. At the end of May 2012, when the Index was reconstituted, its largest stock had a market cap of $2.6 billion. That’s quite a difference in size.
Today, the weighted average market cap of the Russell 2000 is $1.1 billion. By comparison, the smallest company in 2012 in Morningstar’s Small-Cap category had a capitalization of $712 million while the largest was $2.4 billion.
In an attempt to overcome the limitations of defining company size by market capitalization, another method has been used and popularized by BetterInvesting (formerly the National Association of Investors Corp., NAIC, which is also the parent of the SmallCap Informer’s publisher).
BetterInvesting teaches its members that diversifying a portfolio of stocks by company size is one way to help improve the reward-to-risk potential of an investor’s holdings. Large company stocks grow more slowly but are more stable than smaller stocks, while smaller company stocks grow more quickly but are more volatile than larger stocks. Combing them both in a portfolio helps balance out returns over time. Midsized companies are in the sweet spot, offering both growth and a measure of stability and should make up the largest part of the portfolio of an investor seeking long-term capital appreciation.
BetterInvesting’s method of defining companies is to look at the level of their revenues, either in the last fiscal year or the trailing twelve months. In their instructional manuals beginning in the early 1990s, midsized companies were defined as having annual revenues between $400 million and $4 billion (with small and large defined accordingly). By the mid-90s, these breakpoints had grown to $500 million and $5 billion, where they have remained for the past twenty years.
In the mid-2000s, some of ICLUBcentral’s club and stock analysis tools, such as myICLUB.com, StockCentral.com, and Toolkit 6 for Windows, used the above definitions and also added categories for micro stocks (revenues below $100 million) and mega stocks (revenues above $15 billion), in an effort to help steer investors away from these more speculative (on the lower end) and more slow-growing (on the upper end) companies.
The problem with a static definition of company size is that $500 million today just doesn’t go as far as it did twenty years ago. Many long-term oriented, growth stock investors find it hard to discover smaller companies that have the right growth and value attributes but are within the $500 million sales limit.
In fact, according to the U.S. Bureau of Labor, $500 million in 1995 has the same buying power as $782 million in 2014. It’s become clear that a revision to this definition is in order, and that small companies should probably be defined as those that have annual revenues below $1 billion, with large companies having annual revenues above $10 billion. These new definitions are being rolled out in many of BetterInvesting's and ICLUBcentral’s software and web-based tools.
A third possible definition of company size is to consider the long-term or projected EPS growth rate of a company. As far back as 1971, BetterInvesting (then NAIC) published a recommendation that defined large companies has having 5-7% EPS growth a year, smaller companies growing EPS 12% and up annual, and midsized companies showing EPS growth in between at 7-12%.
This method has the advantage of focusing on the key consideration of a growth stock portfolio—the growth of earnings of the component companies. Some large companies when defined by revenues or market cap may have outsized EPS growth rates; likewise, some smaller companies may be growing at puny rates that won’t serve an investor’s overall total return goals as they should.
Over the long-term, a stock’s minimum rate of capital appreciation will approximate the growth of its profit. Dividends will add another boost to returns, as will smart purchases at lower P/E ratios that are typical for a company. (This is how you can invest in a large-cap company that is growing at 7% a year and still achieve a double-digit return over time.)
But it’s the earnings power that is the largest part of a stock’s potential return. By focusing on the expected overall growth rates of the stocks in a portfolio an investor can improve his or her return.
In the investment club portfolio clinics that I conduct around the country, I suggest that clubs calculate the average weighted growth rate of their entire portfolio. This provides a thumbnail for the expected rate of return that it is reasonable to expect from the club’s holdings.