Understanding market capitalization and which may get the highest return
Tuesday, May 10th, 2016
There are three basic market capitalization stocks: Large-cap, mid-cap and small-cap.
Large-cap stocks have a market capitalization of $10 billion or more. To calculate market capitalization, simply multiply the stock price by the number of outstanding shares.
Mid-cap stocks range from $2-$10 billion and would be considered slightly riskier than large-cap stocks.
Small-cap stocks have the highest return potential, along with higher risk. They tend to be more volatile than the other two capitalizations but can give a higher return over a long period of time.
Another stock investing criteria is known as value stocks. These tend to trade at a lower price relative to its fundamentals, including earnings, sales, cash flow, and book value.
Over the long-term, value stocks have outperformed growth stocks, but the periods of growth outperforming value can still last many years. Some investors will end up throwing in the towel on value stocks because the performance of growth stocks is higher.
Growth stock investors don’t care what an investor pays for the fundamentals; they are looking for companies with high growth rates on sales. But again, no one cares about how much they pay for the company…they are blinded by the growth rates.
Generally, growth companies are small to mid-cap companies, but some are large-cap growth companies because the capitalization is based on the current stock price and the number of outstanding shares.
In addition to the risk of investing in growth stocks, if investors are buying small companies, their risk can be very high and under performance can last many years.
In the mid-80s and mid-90s there was a timeframe in which small-cap companies did poorly. This is a good reason not to buy strictly small-cap companies, but rather mix up your portfolio with some mid-cap and large-cap, and the performance should be tolerable.
I highly recommend sticking with value companies throughout the range. While they may underperform growth stocks over certain periods, the ride with value stocks is not as wild as with growth stocks.
An example of a small-cap company is teen retailer Abercrombie and Fitch (ANF), which has a current market cap of $1.7 billion.
Based on the valuation ratios, ANF is a value company because the price-to-sales are 0.48 and well below the industry average of 1.04. The price-to-book value also looks very attractive at 1.3, when the industry is at 6.1. Their price-to-cash flow is 6.7, which is also below the industry average of 9.4.
What concerns me are the current and forward earnings, which make it appear more like a growth company than a value company. The current price/earnings ratio is 48.8, more than double the industry average at 20.8.
Abercrombie reports earnings on a fiscal year, and going out to January 2017, the earnings are $1.19. With a current stock price around $25.50, the forward price/earnings ratio checks in at 21.5. At Wilsey Asset Management, we like to sell companies when they hit a price/earnings ratio of 16.5 times for earnings.
Based on those same earnings-per-share for January 2017, a 16.5 forward price earnings ratio would yield a stock price of $19.64, well below the current price.
If an investor likes this company, they should wait for the share price to fall or the earnings per-share to increase.
A few other points on Abercrombie and Fitch; year-over-year, sales fell 6% when the industry increased by 4.2%. Earnings-per-share fell by 31%, when the industry had a decline of 20%. If I were to buy this company, I would want to understand why their sales and earnings per-share are declining.
The company does have some investment merit because they a have a strong balance sheet, with a current ratio of 2.2. This is the same as the industry and shows they have good liquidity. The debt-to-equity checks in at 25.8%, better than half the industry average at 58.1.
The receivable turnover and the inventory turnover look reasonable. The receivable turnover is at 64.1 and inventory turnover at three times over the last 12 months.
The inventory turnover does not look that good to me, however, it compares favorable to the industry average of 3.3 times over the last 12 months.
Investors will enjoy a 3.2% dividend yield, however with the current sales and earnings, the company is using a payout ratio of 154% and this is unsustainable. And remember, dividends are generally set quarterly by the Board of Directors, and can be reduced or eliminated if they feel maintaining the dividend will sacrifice the company staying in business.
Do you have a question or a company you'd like me to take a look at? Email me at Brent@WilseyAssetManagement.com!
Wilsey is a financial analyst for Wilsey Asset Management and can be heard every Saturday at 8 a.m. on KFMB AM760. Information is provided by Reuters.
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