Micro or mega cap, which is the most attractive?

The table has one other column of information, pertaining to the random stock examples for each category, which has the number of broking analysts that cover each company. Unsurprisingly, the number of broking analysts researching each company drops as the market cap drops. For broking firms to justify the expense of employing an analyst to cover a company they have to believe that they will have clients that use that coverage to either purchase or sell shares in that company. Coverage is also useful in securing investment banking business from a company. Mega Caps receive a high level of coverage because an extremely large number of clients are likely to trade shares in that company and the company is also potentially a very lucrative investment banking client. The column clearly shows the dramatic drop off in broker coverage as market cap shrinks. Smaller companies have less potential to generate commission for brokers and do not offer the same potential for investment banking services. Frankly less investors hold Small and Micro Caps and those companies just do not do large acquisitions that excite investment banks.

This drop-off in broking coverage represents both an opportunity and a risk for the active investor. Let’s start at the top of the pile, literally dozens of analysts pore over every detail that could help assess the value of the Walmarts and Estee Lauders of the share market. That’s a lot of very smart people tasked with a very specific job. Then combine that with the tens of thousands of investors that trade those shares every day in what should be a really good attempt at accurate price discovery. Which altogether should mean that at the big end of town the relationship between share price and value should be pretty tight, most of the time. Mispricings can obviously still occur but tend to be more related to short lived episodes of widespread panic, March 2020 for example, or negative company specific news that damages short term earnings, to which investors often overreact to.

The picture changes a lot as you move down the market caps. Suddenly broker coverage drops to half a dozen for a typical Mid Cap and even less for Small Caps. Price discovery for these smaller companies involves far fewer investors than the Mega and Large Cap space. The potential for dislocation between share price and value has literally sky rocketed. It no longer needs an episode of extreme market fear or bad company specific news for these companies to be mispriced. However, it can swing the other way too, these companies can at times be ridiculously overpriced. Not that long ago a raft of early-stage technology companies were almost certainly massively overpriced relative to their value. This potential for large mispricing at the smaller end of town is a deterrent to a great deal of investors who would rather stick to the “safer” larger caps. However, for the active investor that does their own research and doesn’t rely on broker recommendations the smaller caps represent a fertile hunting ground for companies trading well below their true value. It should also be noted that for the brave that delve into the Micro and Nano Caps there are a large number of companies that have only one broker or not even one providing an assessment of their value. This probably represents the share market’s best chance at being able to buy a company at a fraction of its future worth. However, as Fama & French noted, it comes with some extra risk because when fear hits and the market wants to get risk off, smaller caps generally underperform in the short-term. But in the longer term investors, especially those that do their own research, benefit from exposure to mid and smaller caps. 

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