Fool's Eye View

[ February 22, 2000 ]

Size Matters -- The Effects of Market Capitalisation

By Nigel Roberts (TMFNigel)

Chippenham, Wiltshire -- The market capitalisation of a company is important. The value of a company is arrived at by a fairly simple calculation -- the current share price multiplied by the number of shares in issue. For the private investor, does it really matter what the actual market capitalisation is? Well the answer to this, as with most investing questions, is yes and no.

The decision on a company's inclusion or exclusion in the two main indices, the FTSE 100 and FTSE 250, is based primarily on its market capitalisation. These indices contain the shares in which most of the major fund managers invest most of their money, and these are the most actively traded shares in the market. Can this fact, combined with knowledge of the market capitalisation of companies, be used as an investment strategy? One potential strategy is to buy shares that are likely to be promoted to a "higher" index and sell shares that are likely to be demoted. Index tracking funds are forced by their very nature to buy shares that are in the indices they are trying to track, and so buying or selling ahead of the change may be a viable strategy. The indices are reassessed on a quarterly basis. The company currently at the top of the FTSE 250 table is Baltimore (LSE: BLM); it looks certain to be promoted to the FTSE 100 next time, so would this boost its share price?

The problem with trying to benefit from the promotion of a company like Baltimore to the FTSE 100 is that while fund managers may be Wise, they are not fools (note the small f); they will often try to pre-empt the move and may buy ahead of the change. So there is probably little scope to make a profit, especially when you take into account dealing costs and the spread.

Size can also affect the marketability of a share and the cost of dealing. When buying shares in a smaller capitalised company it is important to check the number of market makers, the normal market size and the spread. Large companies will generally have a large number of market makers and smaller spreads. Small companies may have only one or two market makers dealing in the company, and this can make it difficult to sell, especially when there is bad news about a company. The normal market size (NMS) is also important as if you try to sell more than this, the market maker may refuse the transaction.

Does market capitalisation also affect the bid-offer spread? You bet it does, If you log onto your super online stockbroker and plug in the EPIC code for one of the smallest companies traded on the London market, for example furniture group UNO (LSE: UNO), you will find that today the bid price was 27p and the offer price was 30p. This means that if you want to buy the shares you will pay 30p, and if you want to sell the shares you will get only 27p, so if you bought today you would immediately be sitting on a 3% loss. It is easy to find even worse spreads than this: have a look at carpet producer Stoddard International (LSE: SDD). Today the price to buy was 5.5p and to sell was 4.75p, so if you bought today you would be sitting on an immediate massive loss of 0.75p per share or nearly 14%!

If we were to look at another company, and let's take the biggest on the market, Vodafone AirTouch (LSE: VOD), today you would have found that the price to buy was 338p and to sell was 337p, a difference of only 1p or just under 0.3%. Why the difference? Well one reason is competition. UNO has only 3 market makers, Stoddard has 4 and Vodafone has 382! Of course the bid-offer spread does not only reflect the amount of profit made by a market maker; it also reflects the risk that the market makers are taking. For example, the market maker is taking the risk that he may buy the shares from you but then find that he is unable to sell the shares in the marketplace. In order to sell the shares, he may have to cut the offer price. This obviously eats into any potential profits and may even force him to take a loss. The market maker factors this risk into the spread. Market makers are obliged to make a market in the stocks that they trade, so even if the share price is in freefall and they are only sellers, the market makers will keep on buying. Of course they will adjust the price they are willing to pay down and down until people no longer want to sell. So for companies where the liquidity of the shares is not so high, the risk is great, or where sellers outnumber buyers (or vice versa) then the bid-offer spread tends to be greater.

You can see that the bid-offer spread can take quite a large chunk out of your money. In Stoddard's case, if you decided to buy and then immediately sell (very unFoolish, I might add), you would lose 14% immediately. In addition, you would have to pay your stockbroker commission, which for a small trade of, say, £1000 would be a minimum of £15. Remember this is on both buying and selling, so you would have paid your stockbroker £30. You will also have to pay the government 0.5% of the purchase price in tax (stamp duty). In total you will have lost £175 or 17.5%. Looked at another way, if you buy shares in Stoddard today at an offer price of 5.5p, the shares will have to rise to a bid price of 6.5p for you just to break even.

Remember that the long term return on investing in the stock market has been about 12% per annum, and by buying and selling Stoddard in one day you have lost 17.5%. This is why here at the Fool we encourage people to buy and hold shares. From the figures shown in the previous paragraph you will see how difficult it is to make short-term profits on the stock market. The important thing is to buy and hold and let the effect of compounding work on increasing the value of your shares over the long term. It is therefore vital to spend a lot of time making sure you get the buy decision right before you buy the shares. As Warren Buffett said: "If it's not worth holding a share for 10 years, it's not worth holding it for ten minutes."

One final interesting table -- reproduced from my book (WARNING: BLATANT BOOK PLUG ALERT!!), which you can buy from Fool Books -- shows the typical quoted spreads for the different segments of the market:

Index             Typical Quoted Spread
FTSE100                   0.6%
FTSE250                   1.8%
FTSE SmallCap             3.8%
FTSE Fledgling            8.5%
AIM                      13.5%

So you can see -- size does matter!

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