Capitalization or cap refers to the combined value of all shares of a company’s stock. The lines dividing large cap, mid cap, and small cap are sometimes as blurry as the line between, say, Rubenesque and fat. The distinction is largely in the eyes of the beholder. If you took a poll, however, you would find that the following divisions are generally accepted:
Large caps: Companies with more than $5 billion in capitalization
Mid caps: Companies with $1 billion to $5 billion in capitalization
Small caps: Companies with $250 million to $1 billion in capitalization
Anything from $50 million to $250 million would usually be deemed a micro cap. And your local pizza shop, if it were to go public, might be called a nano cap (con aglio). There are no nano cap ETFs. For all the other categories, there are ETFs to your heart’s content.
How does growth differ from value?
Many different criteria are used to determine whether a stock or basket of stocks (such as an ETF) qualifies as growth or value. But perhaps the most important measure is the ratio of price to earnings: the P/E ratio, sometimes referred to as the multiple.
The P/E ratio is the price of a stock divided by its earnings per share. For example, suppose McDummy Corporation stock is currently selling for $40 a share. And suppose that the company earned $2 last year for every share of stock outstanding. McDummy’s P/E ratio would be 20. (The S&P 500 currently has a P/E of about 15, but that ratio changes frequently.)
The higher the P/E, the more investors have been willing to pay for the company’s earnings. Or to put it in terms of growth and value:
The higher the P/E, the more growthy the company: Either the company is growing fast, or investors have high hopes (realistic or foolish) for future growth.
The lower the P/E, the more valuey the company. The business world doesn’t see this company as a mover and shaker.
Each ETF carries a P/E reflecting the collective P/E of its holdings and giving you an indication of just how growthy or valuey that ETF is. A growth ETF is filled with companies that look like they are taking over the planet. A value ETF is filled with companies that seem to be meandering along but whose stock can be purchased for what looks like a bargain price.
Put these terms to use
Today, most investment pros develop their portfolios with at least some consideration given to the cap size and growth or value orientation of their stock holdings. Why? Because study after study shows that, in fact, a portfolio’s performance is inexorably linked to where that portfolio falls in the style grid.
A mutual fund that holds all large growth stocks, for example, will generally (but certainly not always) rise or fall with the rise or fall of that asset class.
Some research shows that perhaps 90 to 95 percent of a mutual fund’s or ETF’s performance may be attributable to its asset class alone. In other words, any large cap growth fund will tend to perform similarly to other large cap growth funds. Any small cap value fund will tend to perform similarly to other small cap value funds. And so on.
That’s why the financial press’s weekly wrap-ups of top-performing funds will typically list a bunch of funds that mirror each other very closely. (That being the case, why not enjoy the low cost and tax efficiency of the ETF or index mutual fund?)