In the last lesson, you learned that geography is an important distinction. Are there are any categories that might be important?
Let’s look at U.S. stocks.
We know these are different and may perform differently from developed international stocks and emerging market stocks. But do you think there is much of a difference between a company such as Wal-Mart and, I don’t know, maybe the Seattle company, Bill the Butcher, Inc.? Bill the who? Exactly. But this is a real company. I couldn’t make this up even if I wanted.
So Wal-Mart is ginormous and has revenue of nearly $500 billion a year, and our buddy Bill has revenue of less than $2 million a year.
Yes, they are both in the United States and that’s helpful to know, but come on. Huge difference between these two companies. One is large and the other small. Bingo. That’s another way we can categorize stocks: by how large they are.
Examining Market Cap
If you really want to be clever, the size of the company is not technically determined by their sales, but by their market cap instead. Market cap is short for market capitalization. It sounds ominous, but it’s really simple to understand. You just look at the number of total shares a company has and you multiply it by the price of one share. So what you get is the dollar amount it would take if you wanted to buy the whole company. For example, a company has 100 total shares and the stock price for one share is $5; that means you could buy up all 100 shares of the stock and own the company with $500.
Just for fun, how much do you think the market cap of Wal-Mart is? About $250 billion. And Billy the Butcher? About $60,000.
So, yes, one company is bigger than the other, but as an investor, how is this helpful?
Think of it this way. A large company has most likely been around much longer. They probably have lots of customers, cash, and profits. They may have equipment and infrastructure. Because they are so big, they may be able to borrow money a little easier.
“There’s much more risk with a small company, but there may be a lot more growth potential as well.”
If there is suddenly a drop in the economy and people are not spending money and buying things, will a big company like Wal-Mart be affected? Absolutely. But chances are, they are so big and have such resources that they could ride out any downturn. In fact, because they are so big, they could lower prices to attract more clients. It might cost them in profits in the short-term, but they might generate a loyal following and customers even after the economy picks back up.
What about butcher boy? It’s a much different story. They are small. They don’t have the same amount of cash or ability to borrow. If there is a downturn, and they lose a few customers, that could drastically affect their ability to pay their rent and keep going as a company. There’s much more risk with a small company, but there may be a lot more growth potential as well. A large company has already done much of their growing. They are mature. But get a company when it’s small and you could see huge growth over the years. Think about it. Wal-Mart was once a small company, and now it’s worth nearly a quarter of a trillion dollars!
One is not better or worse than the other. The point is that they behave differently from one another but similarly with other stocks in their sub-asset class.
Meaning, most really small companies will face the same challenges in a downturn, yet they may also have greater potential for growth.
It’s important to know if you have a portfolio that consists of small company stocks, like Bill the Butcher, or big company stocks, like Wal-Mart.
So those are the main ways to categorize stocks: by geography – U.S., developed, or emerging markets – and by size – small, mid-sized, or large.
The proceeding blog post is an excerpt from Get Money Smart: Simple Lessons to Kickstart Your Financial Confidence & Grow Your Wealth, available now on Amazon.
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Robert Pagliarini, PhD, CFP®, EA has helped clients across the United States manage, grow, and preserve their wealth for the past 25 years. His goal is to provide comprehensive financial, investment, and tax advice in a way that was honest and ethical. In addition, he is a CFP® Board Ambassador, one of only 50 in the country, and a real fiduciary. In his spare time, he writes personal finance books, finance articles for Forbes and develops email and video financial courses to help educate others. With decades of experience as a financial advisor, the media often calls on him for his expertise. Contact Robert today to learn more about his financial planning services.