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Saturday, July 27, 2013

Are Large Cap Stocks Always the Safest?

Investors looking for a safe bet in the stock market often assume large-cap stocks offer some protection when the market is acting crazy. To some extent, they are not wrong, but they may not always be right.

Large-cap stocks - those with a market capitalization of more than 10,000 crores - may be more stable than smaller stocks in a turbulent market. As with all stocks, if you pick the right one it can perform great, but pick another of the same size and you may be very sorry.

Large-cap financial services stocks got clobbered when the crisis of 2008 broke. Still, many large-cap stocks do well over time and small-cap are more risky, right?

There are two ways to look at this: Some large-cap stocks do well in most market conditions, while small-cap stocks really need an economic boom, at least in their sector, to do well. When they take off, small-cap stocks can score impressive gains.

The other way to look at the relationship between large and small-cap stocks is to use stock indexes, which cover a big share of the market.

The Nifty covers 50 of the leading companies in India. Most of these companies are large-cap stocks. However, the Small Cap Index constitutes lesser known small cap companies.

Using these two indexes, we see a different picture. If you can pick the next small-cap winners, you will be very successful.

Does this mean you should dump your large-cap stocks in favor of small-cap stocks? Of course not.

The question remains: how do you pick winners out of the small-cap stocks? Yes, there is inherently more risk in small-cap stocks, but fundamental analysis should help you find some candidates. Start with a good stock screen to narrow down the crowd of possible investment candidates.

If you don't think you can confidently find winners among small-cap stocks, take our advice and buy best of Small / Micro cap stocks - Hidden Gems.

There is no doubt that large-cap stocks, as a group, are safer than small-cap stocks, however when you get down to individual stocks, the question becomes less clear. Just look at the carnage following the beginning of the 2008 financial crisis. Many large companies found themselves in deep trouble when the credit markets came unraveled.

The following recession plunged the whole global economy. Millions lost their jobs and many of them (and others) lost their houses in developed countries. When consumers see neighbours losing jobs and homes, they quit spending. When consumers quit spending, big (and small) companies go under or severely cut back, causing more jobs to be lost.

Large companies have a better chance of weathering the storms if they have cash reserves and an appropriate level of debt. Of course, no matter the economic circumstances, if a company produces something consumers or, at least a segment of consumers, really wants, the company will thrive (Bajaj Auto, for example).