From notable surges to sharp plunges, small- and mid-cap stocks have attracted a lot of attention.

The spectrum of discussion ranges from investors who entered at elevated valuations to those pondering whether it signifies a bubble or merely a temporary froth, from increased flows in tune of ₹64,000 crore in 2023 in mid- and small-cap funds to temporary suspension of fresh flows by a few mutual fund houses, from regulatory nudges to stress testing results of small cap funds.

An understanding of the relationship between the company size, return potential, and risk is crucial for investment decision making. Generally, market capitalisation corresponds to a company’s stage in its life cycle. Larger companies are seen as more mature, have more diversified business structures, more stable business performance and revenue streams. While mid- and small-cap companies have greater room for expansion to realise their full potential.

Historical analysis reveals that large-cap stocks have lower risks and usually grow slowly relative to small and mid-cap stocks. A widely quoted research by Banz (1981) explains that firm size is a proxy for its risk. Smaller firms tend to have high risk but also have high potential growth, and hence small-cap stocks are expected to generate higher returns than large-market-cap stocks.

Of course, there are notable exceptions to this generalization, more so in current times. There are companies that have achieved dizzying height in terms of market valuations due to intense short-term investor interest. Though such companies are counted in the large-cap universe, they tend to have share-price volatility and earnings profiles more typical of small companies than large-cap ones.

Similarly, there are small size companies with share-price and earnings profiles more typical of large-cap firms.

How should we put numbers to market capitalisation categories?

Alternative approaches

Index providers, broking firms, investment advisors etc., have proprietary guidelines for categorising companies by market capitalisation. SEBI has defined large-cap, mid-cap and small-cap companies through a circular in October 2017. The Association of Mutual Funds of India (AMFI) is stipulated to prepare the list of stocks in accordance of the circular for the mutual funds.

AMFI classifies stocks as large, mid and small caps every six months. Large cap companies are the top 100 companies in terms of full market capitalisation. Companies ranking from 101 to 250, fall under the mid cap segment and companies ranking from 251 onwards are small cap companies.

This categorisation is done in order to ensure uniformity in respect of the investment universe for equity mutual fund schemes. The total market capitalisation, as per the AMFI list, was ₹14,106,663.11 crore when the list was first prepared in December 2017. It reached ₹32,180,276.21 as per the latest available list as on December 2023.

Advances in equity markets have led to an increase in the market capitalisation of each of these groups of stocks, but the number of the stocks in each of these categories has remained the same. Due to rising market capitalisation, the company ranked 100th in the large-cap category has a market capitalisation of ₹67,017 crore in December 2023 as against ₹29,304 crore in December 2017.

In December 2023, a company with a market capitalisation of ₹29,304 crore is below the median size of the mid-cap companies which was ₹34,826 crore. Mutual fund industry has represented to the market regulator to expand the large-cap range from top-100 companies to top 125 companies, mid-cap from 126th to 276th and companies from 277th onwards as small-caps.

Before the SEBI circular, the categorisation of companies was left to the judgment of market participants. The market convention was to define companies with market capitalisation of ₹20,000 crore or more as large cap, companies with market caps above ₹5,000 crore but less than ₹20,000 crore mid-cap, and companies with market cap of less than ₹5,000 crore as small cap. Many stock brokers continue to categorise stocks in this manner.

As per these ranges in December 2017, 131 companies formed part of large cap universe, 231 companies had qualified to be in mid-cap category, whereas in December 2023, 268 companies had crossed the threshold of ₹20,000 crore and 345 companies are in the range of ₹20,000-5,000 crore.

Percentile method

Another convention followed by a few index providers globally is to define categories on the basis of percentile of market capitalisation.

For example, stocks which are part of the top 70 per cent of cumulative total market cap may be considered as large cap stocks, stocks in the next 15 per cent range (between 70 and 85 per cent) of cumulative total market cap as mid cap stocks.

With this method 132 companies will form part of large cap universe, with the lowest market cap of ₹48,709.89 crore.

The advantage of this method is that it is relative to the size of overall market and dynamic in nature. Time has come to revisit the definitions of these categories. The cap-categories should evolve with markets and provide meaningful insights into a company’s risk-return profile within the broad market context.

The writer is Professor & Dean (Academics), School for Securities Education, National Institute of Securities Markets . Views are personal