The price of almost everything in your daily life is determined by the law of supply and demand. What you pay for your lettuce, tomatoes, eggs, and beef depends on how much of each is available and how many people want these items.
Even in former Communist countries, where the difference between haves and have-nots was theoretically nonexistent, supply and demand held sway.
There, state-owned goods were always in short supply and were often available only to the privileged class or on the black market to those who could pay the exorbitant prices.
This basic principle of supply and demand also applies to the stock market, where it is more important than the opinions of all the analysts on Wall Street, no matter what schools they attended, what degrees they earned, or how high their IQs.
Big or Small Supply of Stock
It’s hard to budge the price of a stock that has 5 billion shares outstanding because the supply is so large. Producing a rousing rally in these shares would require a huge volume of buying, or demand. On the other hand, it takes only a reasonable amount of buying to push up the price of a stock with 50 million shares outstanding, a relatively smaller supply.
So if you’re choosing between two stocks to buy, one with 5 billion shares outstanding and the other with 50 million, the smaller one will usually be the better performer, if other factors are equal. However, since smaller-capitalization stocks are less liquid, they can come down as fast as they go up, sometimes even faster. In other words, with greater opportunity comes significant additional risk.
The total number of shares outstanding in a company’s capital structure represents the potential amount of stock available.
But market professionals also look at the “floating supply”—the number of shares that are available for possible purchase after subtracting stock that is closely held. Companies in which top management owns a large percentage of the stock (at least 1% to 3% in a large company, and more in small companies) generally are better prospects because the managers have a vested interest in the stock.
There’s another fundamental reason, besides supply and demand, why companies with a large number of shares outstanding frequently produce slower results: the companies themselves may be much older and growing at a slower rate.
In the 1990s, however, bigger-capitalization stocks outperformed small-cap issues for several years. This was in part related to the size problem experienced by the mutual fund community. It suddenly found itself awash in new cash as more and more people bought funds. As a result, larger funds were forced to buy more bigger-cap stocks.
This need to put their new money to work made it appear that they favored bigger-cap issues. But this was contrary to the normal supply/demand effect, which favors smaller-cap stocks with fewer shares available to meet increases in institutional investor demand.
Big-cap stocks do have some advantages: greater liquidity, generally less downside volatility, better quality, and in some cases less risk.
And the immense buying power that large funds have these days can make top-notch big stocks advance nearly as fast as shares of smaller companies.
