It is also one of the better indicators of liquidity. Certainly it is the easiest to compute. Getting a fix on a stock's liquidity is important, especially for large trades, since it affects the ease of carrying out transactions, and associated costs like brokerage.
That's why it's much easier to buy or sell 10,000 shares of a stock with a large market capitalisation, like State Bank of India (Rs 11,421 crore) than it is to trade as many shares of Karur Vysya Bank (Rs 97 crore). And sometimes, even trading a few thousand shares of an illiquid stock can move its share price significantly. Moreover, it's often impossible to get out of the trap of being invested in an illiquid stock in a falling market.
That's why stock market professionals like to classify stocks by market capitalisation, since it allows them to focus on the category of stocks that best suits their investment needs. There's no watertight rule on the exact size, since it's primarily a categorisation of convenience, but large-cap (large market capitalisation) stocks typically have a market capitalisation of Rs 500 crore and above. Mid-cap stocks are generally in the Rs 100-500 crore range, while small-caps have a market capitalisation of less than Rs 100 crore.
Large domestic mutual funds and foreign institutional investors who deal in thousands of shares at a time rarely look beyond large-cap stocks. Individuals make up the overwhelming majority of investors in small-cap stocks.
If you deal in small volumes of shares, it may not be so important to classify stocks by market capitalisation. Instead, keeping track of the swings in market capitalisation can provide valuable investment opportunities.
Since it indicates the value perceived by the market, market capitalisation is also a good indicator of the desirability of certain sectors. For instance, the cumulative market capitalisation of 'hot' industries like fast-moving consumer goods (FMCG) and software is very high in comparison with that of less exciting industries like finance, and commodity sectors like cement and petrochemicals.
Just five years ago, market capitalisation heavyweights were mostly commodity stocks, like ACC, Tisco or Reliance, where much of the market's valuation was based on the physical assets held by the company. In line with the global trend towards greater valuation for less tangible factors like brands, management quality and business prospects, the market capitalisation of stocks like Procter & Gamble and Infosys Technologies has grown disproportionately.
Unlike short-term movements in share prices, swings in market capitalisation take longer, and give investors plenty of time to modify their portfolios. For instance, till 1994-95, the market capitalisation of the then smoking-hot auto ancillaries sector was close to Rs 3,900 crore (based on June 1995 prices of the 21 largest companies by turnover). The sector lost its lustre in the subsequent automobile industry slump, and by June 1998 the market capitalisation of the same group had dwindled to Rs 2,350 crore, a 39 per cent drop in three years.
Over the same period, the market capitalisation of the FMCG sector rose by 168 per cent, from Rs 12,900 crore to over Rs 34,500 crore. The software sector showed a huge jump of 523 per cent, from just under Rs 1,300 crore to more than Rs 8,000 crore.
Analysts often use the ratio of a company's market capitalisation to its sales or its profits. Because such ratios correlate market sentiment with a company's performance, they sometimes indicate stocks that are undervalued and, therefore, investment-worthy. But it's very important to use other parameters to distinguish these stocks from no-hopers that deserve their poor valuation. Such ratios make the most sense when they are used to evaluate comparable companies, such as those within the same sector.
When a company's market capitalisation is growing, it is initially well correlated with performance. However, once it wins investor confidence, its market capitalisation tends to rise disproportionately quickly. That's often a signal for a correction in the share price due to profit-taking by early entrants.
In a bull run, market capitalisation tends to rise first among large-cap stocks. Mid-caps are next, and small-caps tend to be the last to rise in a big way. This usually signals the end of the bull phase, but inexperienced investors often buy at this stage. More often than not, they burn their fingers.
The author's e-mail address is vatsala@iinvestor.com
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