Are Big Caps Really Better Than Small Caps?

The Motley FoolSome things in life never change. Some things will always divide communities.

For instance, cat lovers will never agree that dogs make better pets. And fans of the Rolling Stones will never admit that the Beatles made better music.

In the world of investing, the divide over big and small cap stocks is unlikely to narrow, ever. Small cap investors will always insist that the best part of investing is to unearth the next Jardine Matheson (SGX: J36) or discover the future Keppel Corporation (SGX: BN4) while they are still tiddlers.

Reinventing the wheel

Big cap fans, on the other hand, argue over the futility of looking for the next stock market heavyweight. After all, stock market giants already exist. So why bother trying to reinvent the wheel.

Of course size isn’t everything. Big caps, or companies with a sizeable market value, have unique qualities just as smaller outfits have their outstanding qualities and attributes too. There are also, it should be said, disadvantages associated with both.

Many investors favour big companies because they are perceived to be less risky. These are businesses that have been around the block several times over; done a lot of heavy lifting in their day and have been tested almost to the point of destruction and still lived to tell the tale.

However, critics like to point out that large companies are not exactly immune from risk. And they have a point. Companies such as Enron, MCI WorldCom and Lehman Brothers were once large companies before they disappeared up their own balance sheets.

Any company can crash, and the value of any share can go to zero. So size will not protect you from the excesses of management and the dangers of the economic cycle.

That said, large companies are, in general, less prone to fail. Their more reliable revenue streams, coupled with a better and broader customer base and access to dependable funding, could help to provide stability and make forecasting more predictable.

The only rooster in the henhouse

Most big caps also have commanding positions in their respective markets. In some cases they may even have near monopoly status, which means they get to enjoy all the advantages of being the only rooster in the henhouse.

But there are downsides to being big. There always are.

The price for greater dependability is richer valuations. Consequently, investors will often have to stump up if they want a piece of a Straits Times Index (SGX: ^STI) company. And many do, which is why blue chips tend to not only command a premium but also stay expensive.

Another obvious detraction of large caps is slower growth. Companies whose products and services can be found just about everywhere are going to find it harder to expand. Small caps, on the other hand, have a lot more room to grow, and that expansion is usually achieved organically.

And there is more bad news to come.

Investors, on the whole, prefer businesses that are easily understandable. However, big companies have a terrible habit of complicating their businesses with mergers and acquisitions.

Stay alert

Quite often these large companies have little choice but to bolt on new businesses to grow. The upshot could be complex accounts that can even puzzle professional number-crunchers.

Whether you like big caps or small caps, Warren Buffett has a useful tip for you.

He once said that he would never take a swing at a ball when it is still in the pitcher’s glove. In other words, find out as much as you can about the businesses you would like to invest in.

Investing opportunities are around us all the time, be they large caps or small caps. The key is to stay alert to the opportunities.

Investing guru Peter Lynch famously said: “If you stay half-alert, you can pick the spectacular performers right from your place of business or out of the neighbourhood shopping mall, and long before Wall Street discovers them“.

He was referring to small caps but his advice applies to large caps too.

So stay alert.

This article first appeared in Take Stock Singapore

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The information provided is for general information purposes only and is not intended to be personalised investment or financial advice. Motley Fool Singapore Director David Kuo doesn’t own shares in any companies mentioned.