The fact that there are thousands of stocks to choose from leads many investors to experience decision paralysis. What's the best sector to invest in? What characteristics should one look for in a company? Are dividends important, or is growth the main objective?
Although these are legitimate questions, there's a better place to begin your search. If you're on the hunt for a great company, then why not start with the biggest and best the market has to offer? In the vernacular of Wall Street, these are known as "large-cap" stocks.
What are large-cap stocks?
The term itself refers to a company with a large market capitalization. What does this mean? As Investopedia explains, it's nothing more than a "fancy name for a straightforward concept: it is the market value of a company's outstanding shares." To calculate it, you multiply a company's stock price by the number of shares outstanding. For example, at the time of writing, ExxonMobil trades for $99 and has 4.3 billion shares of common stock outstanding. This yields a market cap of $426 billion.
The standard threshold for what constitutes "large cap" coalesces around $10 billion. This captures well-known companies like Wal-Mart and Microsoft, as well as lesser-known concerns such as private-equity firm The Carlyle Group and Republic Services, a waste collection and disposal company headquartered in Phoenix.
Complicating the matter is the fact that the S&P 500, the most widely followed large-cap index in the world, sets the bar lower. To make it onto the index, a company need only have a market capitalization of $5.3 billion. "The market cap of a potential addition to an index is looked at in the context of its short- and medium-term historical trends, as well as those of its industry," reads the index's methodology factsheet. "These ranges are reviewed from time to time to assure consistency with market conditions."
Regardless of the precise threshold, however, these are the biggest and best companies in America. Many have been in existence for decades -- some for more than a century. The largest of the bunch -- the so-called "mega-caps" -- are household names with powerful brand recognition and international operations. They are the titans of their respective industries.
How many large-cap stocks are there?
Any estimate of the number of large-cap stocks depends on how you define the term. If the threshold is $10 billion, then 428 make the cut as of August 2014. If $5 billion is the benchmark, then the universe increases to 711.
It's important to note moreover that the number of large caps is a moving target. As stock prices rise and fall, companies on the margin can either attain or lose the coveted designation. The department store J.C. Penney offers a good example. Its market cap over the last three decades has fluctuated between $19 billion and $2 billion.
What drives large-cap stocks?
There is nothing particularly unique about the forces that drive large-cap stocks relative to their smaller counterparts. Generally, all companies are affected by the health of the underlying economy. And because the United States economy is the world's largest, it typically exerts the biggest effect.
More specifically, two macroeconomic forces often impact the performance of the companies underlying large-cap stocks. The first is unemployment. If people aren't employed, they have less money to spend, and economies therefore contract. The second factor is consumer and investor confidence.
Beyond these are a litany of sector-specific factors. For example, while ExxonMobil and Bank of America both benefit from low unemployment, the former's profit is closely tied to oil prices, while the latter's relies more on the relationship between short- and long-term interest rates. Along the same lines, people won't buy Apple's tablets and phones unless the products themselves are in some ways superior to the competition.
What's the advantage of large-cap stocks?
The traditional argument in favor of large-cap stocks is that they are relatively safe due to their size and track record. And along these same lines, it's often assumed that they outperform small-caps during economic slowdowns but underperform when the economy is expanding. But while this is generally true, the issue of relative performance is not as clear-cut as logic seems to suggest.
Consider the chart below. This compares the performance of the Russell 2000 Index, which measures the performance of small caps, to the S&P 500, the benchmark index for large-cap stocks. As you can see, even though the S&P 500 declined less than the Russell 2000 did from the peak in 2007 to the trough two years later, the difference is relatively nominal. By the same token, even though the Russell 2000 has outperformed the S&P 500 since then, it's not ahead by a huge margin.
With this in mind, it's better to think about the advantage of large-cap stocks in terms of volatility. Volatility is measured by "beta," which indicates how much a specific stock's price fluctuates relative to the broader market. Large caps are roughly half as volatile as small caps. According to data from YCharts.com, stocks with a market cap above $10 billion have a median beta of 1.08 compared to a median beta of 2.21 for stocks with a market cap between $250 million and $1 billion.
Along these same lines, an added advantage is that large-cap stocks distribute a considerable portion of earnings to shareholders, while small-cap companies generally do not. These massive and mature companies are past their high-growth days. In order to compensate investors for their slow-moving stock prices, large caps often pay dividends, which they can back up with large, consistent earnings. Roughly 81% of large-cap stocks pay dividends versus just 23% of small-cap stocks.
The bottom line on large-cap stocks
When you consider the advantages of large-cap stocks over their smaller counterparts, it's clear the two serve different purposes. Small caps cater to investors in search of capital appreciation. Meanwhile, large caps are better suited for income investors and those driven by capital preservation. Many investors invest in some of each in accordance with their goals, their risk tolerance, and their ideas of what constitutes a diversified portfolio.
Armed with the knowledge above, consider whether investing in large caps could help you achieve your financial goals.