Alpha Teach Yourself Investing in 24 Hours: An Analysis (part 27)

Stocks (part C)

by

Charles Lamson

Size

When it comes to stocks, size is one primary method for finding the right investment in a particular situation. We use size as a first cut because it is an easy measure that narrows our focus to a smaller group of stocks for further analysis.

The usual way the market measures a company is by market capitalization, also known as market cap. A large company would be known as a large-cap stock, while a small company would be known as a small-cap stock, and so on.

PROCEED WITH CAUTION Companies are measured based on their assets, sales earning, and other marks in addition to being measured by their market capitalization.

Market capitalization is figured by multiplying the number of outstanding shares of a stock by its current price. For example, if XYZ Company has 10 million shares of stock outstanding and the current price is $55 per share, the market cap is $550 million.

You can see from this formula that the market cap of a particular stock can (and does) change every time the price changes or it issues or buys back stock.

Market cap does not tell us anything about the company other than this particular way of looking at size. It certainly does not tell us anything about the quality of the company. A company can have a high market cap and be broke.

JUST A MINUTE Even a company that has never made money can be a good investment. Stock appreciation has made internet companies hot buys.

Near the end of 1999, Amazon.com, the online book-and-everything-else seller had a market-cap of over $32 billion, yet it had never made a penny of profit.

Market Cap and Investment Decisions

So, how does knowing the market cap of a stock help us make an investment decision? One of the things market cap can do is help compare companies of approximately the same size. This information lets us find peers in size and industry.

For example, if we were looking at communications companies in 1999, it might be interesting to compare AT&T ($170 billion market cap) with SBC communications ($175 billion market cap).

Size is just one factor out of many to consider, but it is important to understand what you should expect of companies in different size groups. If one company is acting in a manner that is quite different from what you would expect, it might mean a buy-or-sell situation.

The numbers I am using in this post were generated from a database of  9,351 companies and were captured in late 1999. This database includes almost all publicly traded companies, although most are very small.

TIME SAVER StockQuest, which can be found at www.marketguide.com, is a valuable tool for screening stocks.

The size stocks we will look at in this, and the next couple posts, are ...

• Large-cap stocks---market cap in excess of $8 billion (451 companies)
• Mid-cap stocks---market cap in excess of $1 billion, but less than $8 billion (1,259 companies)
• Small-cap stocks---market cap less than $1 billion (7,641 companies)

However, this post will focus only on large-cap stocks.

Large-Cap Stocks

Large-cap stocks are important because they are often the "movers and shakers" of the market and their particular industries. Where you cut off large-cap stocks from mid-cap stocks is somewhat open to interpretation.

Some systems use a dollar figure, such as $8 billion and up. Others will use a percentage method that takes all the stocks and says the top 5 percent are the number of large-cap stocks.

A problem with both of these systems is that you have a huge gap between the bottom of the large-cap range and the top. Using either the $8-billion figure or the 5-percent range gets you about the same results in terms of the number of large-cap stocks.

PROCEED WITH CAUTION Use some common sense when considering large-cap stocks. Huge gorillas should not be compared to large monkeys.

The range from the bottom of $8 billion to the top of $596 billion is significant. These mega-giants all have market caps exceeding $100 billion, with Microsoft at the top. Is it rational to expect an $8 billion dollar company to behave in the same manner as a $596-billion company?

We remember that our focus is on grouping companies of like size,  so we are not going to be comparing Microsoft ($596 billion in 1999) with Check Point Software ($7.1 billion in 1999). It is not particularly important where you put the mark that designates large-cap stocks, as long as you are consistent in its application.

The Dow Jones Industrial Average, you remember, is made up of 30 of the largest companies in the United States.

Yet, the 30 companies in the DJIA account for only 18.63 percent of the total market value of all stocks (9,351). The S&P 500 accounts for 54 percent of the total market value. Again these numbers are from 1999 when Ken Little wrote this book Alpha Teach Yourself Investing in 24 Hours, which is the subject of this analysis.

As you become more familiar with the numbers used to value and analyze stocks, you will notice that market cap is only one of many, and not a very important one at that. Why, then, are we spending so much time looking at this number?

Our goal here is not to focus on numbers, but on characteristics. The numbers are just to help us collect stocks in like-sized groups. This grouping gives us some basic characteristics to work with in our stock-selection process.

Large-cap stocks, as a rule, are older, more mature companies with lengthy histories. However, the explosion of technology and the Internet combined with the raging stock market have vaulted some very young companies into the large-cap category.

So even as we approach large-cap stocks to get an understanding of what they are and why they are important, we have to temper our assessment with the realization that some of these young shooting stars may not be around as we know them in the next five years.

In many ways, traditional large-cap stocks are the cornerstones of most institutional investment programs. Known as core stocks, these giants may not be nimble, but are not likely to fall, either.

JUST A MINUTE Core stocks are the cornerstones of many portfolios. They are held for the long term and rovide stability.

Moreover, when they do stumble, many have the resources, both financial and personnel to get back on their feet. IBM is a large-cap stock that fell on hard times, but has managed to regain a measure of trust and respect in the market.

Size alone does not guarantee survival, but it certainly helps. Consequently, large-cap stocks are not known for their volatility---that is, rapid swings in price, up and down. Historically, they have added stability to portfolios and income to the bottom line.

A blue-chip stock is the stock of a large, well-established and financially sound company that has operated for many years. A blue-chip stock typically has a market capitalization in the billions, is generally the market leader or among the top three companies in its sector, and is more often than not a household name.

Blue chip stocks are considered the safest of stock investments because they are felt to be the best of their industry, although some folks will call any company in the S&P 500 a blue chip stock because of its market presence.

PROCEED WITH CAUTION Back in the days when most brokers managed peoples' money, they were supposed to only recommend stocks appropriate for their clients. Blue chip stocks were called "widow and orphan" investments because the stockbroker could safely invest their money in blue chips without fear that the recommendation was inappropriate.

Others feel that size alone is less important than a long history of growth in earnings and dividends. There is no one official list of blue chip stocks, but you could certainly have to consider the 30 stocks in the DJIA as potential candidates, even though one of those stocks is Microsoft, a mere pup in this rarified atmosphere of elder companies.

Large-cap stock characteristics are covered in the following sections.

Heavy Trading Volume

Large-cap stocks tend to have fairly heavy trading  volume day in and day out, regardless of news and market conditions. They are frequently, but not always, among the top trading volume leaders.

This relatively heavy trading volume usually means it is fairly easy to buy and sell the stock. It also means that the market is constantly repricing the stock. This is important because prices are more reflective of the market assessment of the stock when it is heavily traded.

Followed Closely by Media and Analysts

The financial press and stock analysts follow large-cap stocks very closely. Because they tend to dominate the market, it is important news when something happens.

This attention makes it easier to find information about the company and what other people think about its worth as an investment. This access to information will make your job of picking stocks easier.

Tendency to Be Less Volatile

Large-cap stocks, especially the older ones, tend to be less volatile, meaning there is a smaller variation between the high and low during daily trading.

PROCEED WITH CAUTION Some institutional investors (endowment funds, charities, and so on) are more interested in stability than superior returns.

This does not mean that large-cap stocks cannot rise and fall fairly dramatically. During the last quarter of 1999, AT&T's price was up over 20 percent in four weeks on some positive news releases.

In regular markets, where there is no positive or negative news, large-cap stocks will tend to trade in a narrow range. This is the stability institutional managers look for in the large-cap stocks.

DJIA and S&P 500 Members

Large-cap stocks will be found in the DJIA and the S&P 500 Index, so these market indicators are important.

Certainly all the 30 members of the DJIA are large-cap stocks. Many of these are core, blue chip stocks as well.

JUST A MINUTE Ranking companies by size alone only tells part of the story. Dig deeper to see how the company is using its size to its advantage.

The S&P 500 is viewed by many as a gauge of large companies in the market, even though some of the members are quite small (under $1 billion market cap). This is because the S&P 500 represents not the 500 largest companies, but the most important 500 companies (in the opinion of Standard & Poor's).

Small Growth Potential

Large-cap stocks, especially the older core stocks, are usually characterized by a smaller growth potential than smaller companies. This does not mean they are not growing and, in the case of the new high-technology members, may not be true at all.

Many of the large-cap stocks grow more by acquisition and merger than increasing market penetration. Mergers and acquisitions do not always work out, but the market often rewards large-cap companies that open new markets or swallow competitors with higher stock prices.

*SOURCE: ALPHA TEACH YOURSELF INVESTING IN 24 HOURS, 2000, KEN LITTLE, PGS. 181-187*

END

PROCEED WITH CAUTION

Companies are measured based on their assets, sales earning, and other marks in addition to being measured by their market capitalization.

JUST A MINUTE

Even a company that has never made money can be a good investment. Stock appreciation has made internet companies hot buys.

TIME SAVER

StockQuest, which can be found at www.marketguide.com, is a valuable tool for screening stocks.

PROCEED WITH CAUTION

Use some common sense when considering large-cap stocks. Huge gorillas should not be compared to large monkeys.

JUST A MINUTE

Core stocks are the cornerstones of many portfolios. They are held for the long term and rovide stability.

PROCEED WITH CAUTION

Back in the days when most brokers managed peoples' money, they were supposed to only recommend stocks appropriate for their clients. Blue chip stocks were called "widow and orphan" investments because the stockbroker could safely invest their money in blue chips without fear that the recommendation was inappropriate.

PROCEED WITH CAUTION

Some institutional investors (endowment funds, charities, and so on) are more interested in stability than superior returns.

JUST A MINUTE

Ranking companies by size alone only tells part of the story. Dig deeper to see how the company is using its size to its advantage.