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  • The 'cap' confusion

    Article by Jayant Pai in Afternoon DC, June 5, 2017

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    Different agencies define large, medium or small cap, according to their own methodology. Understand them better...

    We humans find comfort in classification and segmentation. That is why many of us prefer the well-demarcated aisles in supermarkets, rather than popping into the local grocer's cluttered store. We extend the same desire to investing and consider it especially important when there are over 4,000 listed stocks and hundreds of mutual fund schemes.

    A common method of classification is the market capitalisation (MC)-based method, wherein stocks/funds are divided into large-cap, mid-cap and small-cap. MC is the product of the market price and the number of equity shares outstanding. It may be computed either on a total or a free-float basis. Many investors have a clear preference regarding the category they would like to invest. While some stick to large-caps, others gravitate towards mid-cap and small-cap stocks.

    However, their definition varies widely. For instance, the Bombay Stock Exchange (BSE) considers stocks falling within the first 80% of the free-float market capitalisation as large-caps and those within 80-95% as mid-caps while computing their indices. The National Stock Exchange (NSE) considers stocks falling within 75% and 95% of the free-float market capitalisation as part of the eligible universe, while computing the NSE MidCap Index.

    Even mutual funds differ markedly. For instance, some schemes use an 'absolute' filter of stocks with a market-cap between ₹ 150 crore and ₹ 1,500 crore. What constitutes small-cap for some may be micro-cap for another.

    Here's some solution to the segmentation conundrum:

    Strike a balance: Rather than obsessing over the classifications, investors could opt for clear options within each category. For instance, a BSE Sensex Index Fund will most certainly be a large-cap scheme. Alternatively, you could opt for 'go-anywhere' funds, which operate without any overt market-cap bias. However, even in these, the fund’s philosophy will lead to a tilt in some direction. Choose the one whose style you are comfortable with.

    Choose appropriate funds: Ensure the large or mid-cap fund you are investing in is true to its mandate. Funds which frequently modify their mandate end up confusing and disappointing investors.

    Be cognisant of biases: Often, the preference for one category over the other may be due to 'recency bias'. If stocks or indices belonging to a certain category outperform for some time, investors gravitate towards that class. For instance, if mid-cap indices are outperforming large-cap indices, the demand for mid-cap schemes will rise, while there may be outflows from large-cap schemes. Beware of falling prey to such 'clustering'. Invest as per your financial goals and asset allocation, not by what popular at this moment.

    Disclaimer: Views are personal. Names of individual stocks have been used for representative purposes only, and should not be construed as a recommendation.

    The original article could be seen here.

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