Talking Shop with David Koch:What is a stock? Part 2

By David Koch, CFP®, AIF®, CFA, Senior Wealth Advisor

Part 2:  Large Cap, Small Cap, International, Emerging and Frontier Markets

”What is a Stock?” is a 4-part piece from our Advisor Insights series Talking Shop with David Koch. If you missed it, read Part 1:  Shares outstanding, IPOs, and Buybacks

Remember, when you see the price of a stock, you’re looking at the price of one share. The price of a company’s stock, though, is somewhat arbitrary. If a stock is trading at $100 per share, the company can easily make it $50 per share by doing a split – now everyone has twice as many shares, but they’re only worth $50 each. Want to turn a $50 stock into $100? No problem, the company can do a reverse split.

What’s a company worth?

If you want to evaluate the value of a company’s equity, you need to know how many shares they have outstanding, then multiply that number by the current price. This is called the market capitalization of a company, AKA the market cap.

At the time of this writing, Apple is trading at about $330 per share and has about 4.3 billion shares outstanding – which gives it a market capitalization of roughly $1.4 trillion. Costco shares are trading at about $320 per share, but they only have about 441 million shares outstanding, so while their share price is only $10 apart, Apple is worth more than three times as much.

About share prices

Some companies may like to keep their share price within certain price boundaries in order to attract certain types of traders. The thought is that a smaller share price is more accessible to smaller investors. So keeping the share price low makes things more egalitarian – and also possibly makes it easier to trade because more people are trading it (this is also known as being “more liquid”).

A company will do a split when their share price gets too high. Some companies may never do a stock split and want to keep their share price high because they don’t want people trading it, possibly thinking that may dampen volatility. Whether either of these strategies works is anyone’s guess.

Capitalization – and cap size

Companies with a large market capitalization are called large cap. Then there’s small companies that are called small cap, and in between large and small is mid cap. Smaller than small is micro cap, smaller than micro is nano cap. A set of several or many companies belonging in the same group, whether in terms of cap size or a different attribute like market type, can be called an index. A mutual fund or Exchange Traded Fund (ETF) that invests in an index is called an index fund. More on that later.

People draw the lines between large, medium and small in different places. S&P has the S&P 500, which is more or less the 500 largest companies in the U.S. But the S&P 500 does contain some midcaps since the index is constructed by a committee. It also can include non-U.S. companies such as Royal Dutch Shell. Russell has the Russell 1000, which is mechanically constructed and consists of the largest 1,000 companies domiciled in the U.S., though they will adjust for significant cross ownership (when one company owns a significant amount of another). Both are considered a large cap index.

The Russell 3000 is made up of the largest 3,000 U.S. companies (with the Russell 1000 being comprised of the largest 1,000 of these and the Russell 2000 the smallest 2,000). The most well-known index of large stocks, the Dow, has only 30 companies in it. The Dow uses a price weighting scheme that makes it difficult to interpret. It’s considered an historical artifact because when it was designed it was intended to provide a rapid snapshot of market behavior and was easy to calculate. However, the advent of modern computers has rendered its value pretty minimal. The S&P 500 is a much better indicator of the U.S. market (read more here: The Dow is Not Your Benchmark); the Russell 2000 (R2000) is the most frequently quoted index of small stocks.

Different index providers, as I mentioned above, draw different boundaries between capitalizations. But here’s a very general rule of thumb: A large cap company has a market cap of over $10 billion. A mid cap company has a market cap between $2 billion and $10 billion, and a small cap company has less than $2 billion in market cap. Micro cap is less than $300 million and nano cap is frequently applied to companies with less than $50 million.

Beyond U.S. markets

International investing has all the nuances of domestic investing but with the added variable of currency exchanges between the dollar and foreign currencies. This makes things even more interesting. You could see a respectable performance from some investment in Europe, for example, but if the dollar has a strong year against the Euro, you could end up with a loss once the currency gets exchanged back.

Likewise, you could make some terrible investments internationally, but if the dollar is weakening you could still turn a profit. Currencies tend to ebb and flow and over the long term mostly likely wash out in terms of impact – what matters most is whether these were good investments in the first place.

“Developed” is the term investors use for what was once called 1st world countries; think Europe, Canada, Australia, etc. “2nd world” countries were the Soviet Union, Cuba, and their cohorts – these were not widely investable by Americans during the Cold War. In the 1980s what we called 3rd world countries became widely referred to as the Emerging Markets (EM).

By and large, the folks at Morgan Stanley Capital International (MSCI) continue to determine which countries are categorized as being in the EM index. Interestingly, the 2nd-largest economy in the world, China, is still classified as EM. In fact, MSCI caps Chinese stocks at comprising 33% of their EM index. This cap is needed, as at times the capitalization of China’s stocks can take up as high as 50% of all of the emerging markets combined.

Some “developing” countries may have a stock market, but may not be very accessible to investors. MSCI may keep them out of their EM index and categorize them as Frontier Markets (FM). Think Nigeria, Lebanon, Serbia, and Slovenia. Some countries have such small (and/or bad) capital markets that MSCI doesn’t add them to either the EM or FM indices: They call them standalone markets – think Palestine, Malta, or Botswana.

The changes back and forth among the indices are also interesting. Some recent changes include: In 2013, Greece was downgraded from Developed to Emerging (Greece is still “emerging” after 14,000 years?) and Morocco was downgraded from EM to FM. In 2015, Ukraine was moved out of EM and into standalone after the Russian military intervention there. And Saudi Arabia was moved from standalone to EM after the country’s leaders announced they were taking their state-owned oil company, Aramco, public. Aramco was valued at $1.7 trillion at the time of IPO – yeah, trillion.

What makes investing in the Emerging Markets so interesting is how much they’re all so different. Some countries in EM have highly sophisticated technology and manufacturing companies that compete on the world stage (think Korea); others have limited rule of law and/or are at the mercy of virtual dictators; some have very sound banking and finance systems, others not.

Lastly, the BRICS

BRIC is an acronym for the developing nations of Brazil, Russia, India, and China. These four are expected to become dominant suppliers of manufactured goods, services, and raw materials in the coming generation. China and India will become the world’s dominant suppliers of manufactured goods and services, respectively, while Brazil and Russia will become similarly dominant as suppliers of raw materials. As of 2010, South Africa joined the group, which is now referred to as BRICS.

Next up, in What is a Stock Part 3, I’ll discuss active, passive, and factor investing.

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Disclaimer: 

The views contained herein are not to be taken as an advice or recommendation to buy or sell any investment. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without previous notice. This material should not be relied upon by you in evaluating the merits of investing in any securities or products mentioned herein. In addition, the Investor should make an independent assessment of the legal, regulatory, tax, credit, and accounting and determine, together with their own professional advisers if any of the investments mentioned herein are suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment.