Mix big with small to spread the risk

Q. I have read that your share portfolio should have a mixture of low, mid and high cap shares. What does this term cap refer to, and how do you determine the category a company fits into?

A. Cap is short for capitalisation, often called market capitalisation.

It is a measure of company size on the share market. More precisely, it is the number of shares outstanding times the share price.

When somebody says you should mix low, mid and high cap shares, then, they are really saying you should hold shares in companies of different sizes.

And that is a good idea. Quite often, when large company shares aren't doing well, the smaller ones are, and vice versa.

In recent times in New Zealand, smaller company shares have tended to do much better than those of large companies.

Over the past year, for instance, the NZSE-10 Gross (including dividends) Index, which is basically made up of the biggest 10 listed companies, grew about 4 per cent.

But the NZSE MidCap Gross Index - no prizes for guessing its makeup - grew about 7 per cent. And the NZSE SCI (small cap index) grew 9 per cent.

If we go back five years, the differences are even more marked. The big company index decreased 11 per cent; the middle one grew 46 per cent and the small one grew 57 per cent.

Why the difference?

In some ways it is easier for small companies to do exceptionally well. They tend to be in rapidly growing industries. And a tiny company can double its market share, from 2 per cent to 4 per cent, much more easily than Telecom can.

Often it can also adapt to new technology and economic developments more easily than a big company. And the manager and other employees are more likely to be shareholders, giving them extra incentive to perform well.

Another possible reason is that big financial institutions don't usually buy shares in small companies, simply because there aren't enough shares for them to bother with. This lowers total demand, which keeps prices down.

And small companies are more likely to be taken over, which can do wonders for their share price.

On the other hand - and it is important to remember this - smaller companies are more likely to go bankrupt or just close down.

They tend to be over-represented on lists of both the biggest gainers and biggest losers on share markets.

With more volatile prices, shares in small companies tend to bring in higher average returns. It is the market's way of rewarding shareholders who take on the greater risk.

That certainly doesn't mean, though, that you'll always do better with shares in small companies. There have been plenty of periods in New Zealand and overseas markets when they have performed worse than larger companies.

The wise investor holds a mixture.

One way to find a company's capitalisation is to go to New Zealand Stock Exchange. Click on Listed Companies and then on the individual company you are seeking. Or you could ask a stockbroker.

To get you started, the companies in the NZSE-10 and their market caps at the time of writing, are: Telecom (around $9.3 billion), Carter Holt Harvey, ($2.8 billion), Contact Energy ($2.2 billion), The Warehouse ($2.2 billion), Auckland Airport ($1.9 billion), Sky City ($1.5 billion), Independent News ($1.3 billion), Sky TV ($1.3 billion), Fletcher Building ($1 billion) and Fisher & Paykel Healthcare ($1 billion.)

One last point: Because small cap shares tend to be riskier, if you invest in them it is particularly important that you spread your risk over many different companies.

As Rex Sinquefield, a researcher in the field, has said, if you bought 30, you could get lucky with those 30, or very unlucky. He recommends getting into hundreds, or preferably 1000 or more, different companies.

For most of us, that means investing in a fund that in turn buys shares in many small companies.

* Mary Holm is a freelance journalist and author of Investing Made Simple

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