Small caps represent a promising option when it comes to investing in stocks. This type of investing involves investing in smaller public companies whose stock has yet to reach its full market potential. With this strategy, investors take advantage of potentially out-sized returns from stocks trading at a discount compared to their large-cap brethren.
However, small-cap investing requires detailed analysis and research to identify the most attractive opportunities since many can be absolute failures. We will cover some basics about small-cap investing, why it might be worth exploring for asset allocation decisions, and the cons of including them in your portfolio.
What Is Small-Cap Investing?
Small-cap investing refers to investing in companies with smaller market capitalizations. These companies generally have a market capitalization between $300 million and $2 billion.
Above $2 billion would be a mid-cap and large-cap, while below $300 million would be considered a microcap.
Market cap – or market capitalization – refers to the total market stock value. For example, let’s say that a business had one million stock shares available, and their stock price was $50 per share. At that price, the market cap of this company would be $50 million.
A higher stock price can push a total market cap higher, while a lower stock price can push a cap lower. Companies may be tempted to offer more stock shares to increase their market cap, but doing so tends to dilute the value of shares already on the market.
A company can move in and out of the small-cap market cap. A gain in share price will increase the market cap, while a loss will decrease it. Small-cap stocks tend to want to become larger and get “promoted” to the mid-cap stocks, as doing so means more investors who look at mid and large-cap stocks will be interested in them.
Small-cap stocks run the gamut. On the one hand, they may be the hot new company that will be a large cap before you know it. Many major companies – including Amazon and Tesla – started as small-cap investments, only to see their total stock value show massive returns over time.
When investing in a small-cap stock, you are taking a chance: You are hoping that the business you are investing in will ultimately prove to be the next big thing.
At the same time, a small-cap stock may also represent a company with little time left. Many businesses hit the small-cap range on their way down and when they are headed toward bankruptcy. Your challenge is researching the performance of the small-cap stock you may want to invest in.
It is essential to distinguish between small-cap stocks and penny stocks—a penny stock trades for less than $5 per share. A stock can be classified as a small-cap without being categorized as a penny stock. Most penny stocks are traded over the counter through the OTC Bulletin Board (OTCBB), commonly called “pink sheets.”
Pros of Small-Cap Investing
Fortunately for investors, small-cap stocks offer many investments, including the following:
Many invest in small-cap stocks because they think they get an inside track on the “next big thing.” Because small-cap stocks are often in their infancy, individuals who invest in them often do so because they show growth potential, particularly when compared to the bigger stocks of the large-cap market.
Institutional investors – meaning pension funds and major investment funds – tend to invest in larger and more stable companies. These investments, of course, can drive the price of stocks up.
Small-cap stocks have a greater risk, often meaning that these hedge funds or mutual funds steer clear of them. Less demand means lower prices and creates more of a buying opportunity for individual investors to buy stocks cheaper.
Higher Historical Returns
Small-cap stocks tend to be less expensive and have historically outperformed large caps. However, the performance data since the Great Financial Crisis has not been positive in recent decades.
In 1992, Eugene Fama and Kenneth French discussed the small cap premium in their influential paper, “The Cross-Section of Expected Stock Returns,” introducing size as a factor with the potential to outperform the broader stock market. However, past performance is no guarantee for future performance, and there are no indications that the small cap premium will exist.
Investors who prefer value investing have incorporated the size and value factors to bias their portfolio with small-cap value stocks. Small-cap value ETFs like VBR (from Vanguard) have attempted to simplify the factor screening process.
Lower Barriers to Entry
Because small-cap stock companies tend to have lower prices, they don’t price out investors with limited capital. For investors, you can afford to buy small-cap stocks – particularly compared to their larger counterparts. It might matter less, with most brokerage firms permitting fractional investing.
Due to the large tech companies dominating the index, you might not receive as much diversification if you stick to investing in the S&P 500. Apple, Microsoft, Alphabet (Google), Amazon, Nvidia, Tesla, and Meta (Facebook) collectively account for 28% of the total value of the S&P 500 Index.
A downturn in the tech sector similar to the dot com crash could have consequences for your overall portfolio.
Cons of Small-Cap Investing
Of course, an investment with small caps presents you with many potential opportunities, but there are many pitfalls and risks that you also need to consider.
Time and Effort Investment
Small-cap companies do not have a lot of analyst coverage. They don’t have the long track record, institutional experience, or history that large-cap stocks have.
It can be difficult for you to make comparisons and gain access to accurate information. As a result, they could end up being “hidden gems” or “lumps of coal” unless you spend a lot of time and effort.
Many small-cap stocks fluctuate wildly in price, particularly in a bear market or anticipation of an upcoming recession. If you are interested in stability, you may find real challenges with these investments, preferring to invest your limited funds in larger companies instead.
While small-caps stocks have some solid growth potential, the flip side is also true. A newer company with a new concept or less history is likelier to fail than a significant, blue-chip company.
A significant investment in a small-cap firm that goes bankrupt may threaten your personal finance. That’s not to say that you shouldn’t make these investments, of course, but that you must do so with this risk in mind.
Potential Liquidity Challenges
The entire approach to the stock market is the idea that someone else wants to buy your stock. If you invest in a small-cap stock, you may find real challenges. After all, people may not be familiar with your company.
As a result, you may have a harder time getting rid of your stock – and may even need to sell it at a lower price. This is further compounded by lower institutional demand for small-cap stocks than for large firms.
Interest Rate Sensitive
Given their growth phase and limited profitability, small-cap stocks are particularly vulnerable during risk-averse periods or rising rates.
Best Small Cap Funds
Many small-cap index funds allow you to invest in several small-cap stocks. You can invest in these via a small-cap ETF or small-cap mutual funds.
These risk-reduction investment methods allow you to start investing in small caps without taking on the risk of putting all of your eggs in one basket. In so doing, you can invest in small companies without worrying that the one company you are investing in will go bankrupt and cost you your entire investment.
You can track small-cap stocks by accessing numerous indexes, including the Russell 2000 or S&P SmallCap 600 Index.
Some of the famous small-cap funds are
- iShares Russell 2000 ETF (IWM): This Blackrock ETF aims to track the performance of the Russell 2000, widely recognized as the premier index for small-cap stocks with a 0.19% expense ratio.
- Vanguard Small-Cap ETF (VB): If you are a fan of Vanguard Funds, VB aims to track the performance of the CRSP US Small Cap Index, which measures the investment return of small-capitalization stocks with an expense ratio of 0.05%.
- Schwab U.S. Small-Cap ETF (SCHA): The Schwab ETF tracks the Dow Jones U.S. Small-Cap Stock Market Index’s total return with a 0.04% expense ratio.
Although several websites list popular small-cap stocks, the changing definition of market capitalization means that some companies start as small-cap, only to see their value explode. The fact that total market capitalization rates change so frequently means that by the time you read this article, a company you researched may no longer be considered a small cap.
That creates a real challenge for investing in well-known small-cap stocks. Instead, many investors use stock filters or the advice of professionals to get information on what small-cap stocks they can invest in. These up-to-date filters have many advantages, not the least of which is they can account for various factors, including risk tolerance, interest rates, and the preferences of individual investors.
What Is the Best Approach to Small-Cap Investing?
This is an almost impossible question to answer. As noted above, appropriate small-cap investing will change based on your investment goals.
Are you a day trader or planning for early retirement?
Do you want a stock with dividends, or do you want to invest in a small-cap company aiming to make significant financial gains in the upcoming years?
Do you need the invested money in the short term, or are you willing to hold the stocks till they become mega caps like Amazon creating generational wealth?
While the approach to small-cap investing with publicly traded companies varies from person to person, most investors seek to achieve at least some level of diversity within their stock portfolio. This means that at least a portion of your investments should be made in businesses from the small-cap universe.
Doing so gives you at least a piece of your portfolio a chance to potentially buy into the subsequent significant stock gain. Remember, a wide swath of major stocks started as small-cap companies, including many of today’s blue chips.
Opening yourself up to the potential risk of small-cap investment means that you gain the opportunity to see significant stock gains.
Of course, picking individual stocks will involve a lot of time and effort. And you have to be lucky. For every Amazon.com, there is a Pets.com. Cash flow is a significant issue for most small-cap stocks to survive in bear markets.
Similar to real estate investing, you have several key metrics to evaluate, such as earnings and revenue growth, price-earnings ratio (P/E), price-sales ratio (P/S), and earnings per share (EPS).
As always, you must research and consult with financial advisors before investing in individual small-cap stocks. By analyzing the stock price, past performance, and other fundamentals, you can protect your valuable investments and best position yourself to make significant financial gains in the future.
John Dealbreuin came from a third world country to the US with only $1,000 not knowing anyone; guided by an immigrant dream. In 12 years, he achieved his retirement number.
He started Financial Freedom Countdown to help everyone think differently about their financial challenges and live their best lives. John resides in the San Francisco Bay Area enjoying nature trails and weight training.
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