Small Cap Stocks – Why Consider Small Companies to Invest in?

Small Cap Stocks

Small Cap StocksSmall cap stocks are listed companies that have market capitalizations ranging from $100 million to $2 billion. However, the share prices of these companies can have big fluctuations over a short period of time.  Companies with market caps of $4 to $10 billion can fall into this category, depending on the industry.

Small-cap stocks are stocks of companies with relatively small market capitalization.  A stock is a small-cap stock when the total value of all of the company’s shares outstanding falls roughly between $300 million and $2 billion.  This includes the shares held by all shareholders, including company insiders. Small-cap companies are often young companies.  They often have growth potential, but they may also have less stability and market share than larger, established companies.  That’s exactly how it tends to play out with small-cap stocks. The risks may be higher versus larger-cap stocks, but the rewards may also be greater.

Some of the best investment stories of the past 25 years started with investors who recognized the potential of a small-cap stock. Just think of being an early investor in a company like Amazon (NASDAQ:AMZN), which was a $7 stock in 1998, or Tesla (NASDAQ:TSLA), which had a market cap of just over $1 billion in 2010.  Of course, not every small-cap stock becomes a giant. Investing in the stocks of small companies can be very rewarding, but it comes with risks that investors need to understand.  (Source: fool.com)

Small Cap Stocks – Historical Performance

Since 2000, small-cap stocks have outperformed large-cap stocks over the long term by 2% per year. But the story is often different over shorter periods like three to five years.  This is because small-cap stocks tend to be more volatile than larger companies.  They tend to have bigger ups and downs in their prices. Over longer periods, those ups and downs will tend to average out.

In 2020, for example, small-caps have vastly underperformed their large-cap counterparts. In the first half of the year, the small-cap Russell 2000 index lost 13.6%, while the large-cap-focused S&P 500 gave up only 4%. Large-cap companies are more likely to be profitable, have ample cash on their balance sheets, and have better access to capital, making them less risky in a crisis like the COVID-19 pandemic. Investors feel safer with large-cap stocks and many likely moved money out of small caps and into large caps during the pandemic. Of course, in a recovery you would expect small-cap stocks to outperform, as these stocks have greater growth potential. (Source: fool.com)

How to Calculate Market Cap

Market cap—or market capitalization—refers to the total value of all a company’s shares of stock.  Market capitalization is calculated by multiplying the number of shares outstanding of a company by the current share price.

Small Cap Stocks – Overlooked by Institutional Investors?

Investing in small-cap stocks provides the opportunity to beat institutional investors. This is because mutual funds have restrictions that limit them from buying large portions of any one issuer’s outstanding shares.

Some mutual funds would not be able to give the small-cap a meaningful position in the fund. The fund would usually have to file with the SEC to overcome these limitations. When a fund does this, it means tipping its hand and inflating the previously attractive price.  Keep in mind that classifications such as large-cap or small-cap are only approximations that change over time. Also, the exact definition can vary between brokerage houses.  For example, as of January 2019, Shutterfly, Inc., has issued 32.98 million shares and had a current share price of $45.45. Following the formula, Shutterfly’s market capitalization was approximately $1.46 billion. Most brokerages consider the company to be a small-cap company.  (Source: investopedia.com)

Investing in Small Cap vs. Large Cap Companies 

As a general rule, small cap companies offer investors more room for growth.  On the other hand, they expose investors to greater risk and volatility.  Large cap companies have a market capitalization of $10 billion or higher. With large cap companies, the aggressive growth phase has already occurred.  As a result, their larger size offers investors stability as opposed to aggressive growth.

Historically, small cap stocks have outperformed large cap stocks. Having said that, whether smaller or larger companies perform better varies over time based on the broader economic climate. For example, large cap companies dominated during the tech bubble of the 1990s, as investors gravitated toward large cap tech stocks such as Microsoft, Cisco and AOL Time Warner.12 After the bubble burst in March 2000, small-cap companies became the better performers until 2002, as many of the large caps that had enjoyed immense success during the 1990s hemorrhaged value amid the crash. (Source: investopedia.com)

Small Cap Stocks vs. Midcap 

Investors who want the best of both worlds might consider midcap companies.  These have market capitalizations between $2 billion and $10 billion. Historically, midcap companies offer more stability than small cap companies.  Still, they offer more growth potential than large-cap companies.  For self-directed investors, sifting through small cap offerings can prove to be time well spent. That is because great small cap investments may be overlooked and under the radar of analyst coverage. Limited coverage allows important company news, developments, and innovations can go unnoticed. By comparison, news coming out of the large tech companies makes instant headlines.

Are Small-cap Stocks for you?

Are you willing to hold an investment for several years? Can you handle volatility? Are you comfortable with a stock that may have big price swings, both up and down? If so, then small-cap stocks might have a place in your portfolio.

As we’ve seen, small-cap stocks can add to your overall portfolio’s growth rate, as long as you have the time to smooth out the ups and downs. But remember that small companies have less room for error than larger, established companies, as was recently demonstrated again by the coronavirus pandemic. Therefore, it’s important to do your homework before investing in a small-cap stock.  Of course, you don’t have to pick individual stocks to get the benefits of small-cap stock investing in your portfolio. For many investors, owning a small-cap mutual fund or ETF as part of a diversified portfolio will be the best way to benefit from the potential of small-cap stocks.  (Source: fool.com)

Small Cap Stocks – Advantages

  • Growth potential – Small-cap companies have greater growth potential. It’s easier for them to grow because they have a smaller operational and financial base. Relative to bigger companies, small-cap companies show significantly higher growth potential. Most small-cap companies enjoy a larger room for future growth compared to large-cap companies, making them attractive options for investors.  For small-cap companies, it is easier to grow significantly their operational and financial base than is the case for most large-cap stocks.
  • Recover quickly during up-cycles – Small-cap companies do especially well early in an economic recovery. That’s because interest rates are still low. It gives them easy access to funds to invest in their growth.
  • Can be undervalued – Small cap stocks aren’t as well covered by the financial media as larger companies are. This provides an advantage. The upside is that there are more companies whose stocks are misunderstood and potentially undervalued. Careful research can reveal which companies have been overlooked by larger investors. Information about the small-cap stocks is harder to find compared to large and mid-cap companies. Analysts typically give little attention to these companies.  As such, there is a high probability of mispricing of small cap stocks. This situation creates opportunities for investors to leverage market inefficiencies regarding pricing.  Ultimately, there are opportunities to earn a great return from these investments.

Small Cap Stocks – Disadvantages 

  • Greater risk – Their small size also makes them riskier investments. They don’t have the financial cushion to withstand crises or poor management.  They are also riskier stocks during an economic downturn. Smaller companies are more likely to fail in a recession.
  • Harder to research – Face it, it takes a lot of time to research small-cap companies. The information is not as widely available, so it takes longer to find it and dig out the details. Even though you can get information from the annual report and the internet, there’s less history. You will also have a harder time finding secondary news reports and analysts’ summaries.

Small-Cap Companies’ Impact on the Economy

Small-cap companies are an important engine for job creation. Small businesses contribute to the majority of all new job growth.  The federal government focuses on helping small businesses with loans and grants.

A small-cap company is typically well past the initial start-up phase. It has to be doing well enough to qualify for an initial public offering (IPO). Before a small business can issue an IPO, it must satisfy an investment bank that it is a well-run firm. Even though small-cap companies are riskier than ​mid-cap or large-cap companies, they are less risky than investing in a venture before it’s gone public.  An IPO takes a small business from the private equity phase to being a publicly owned company. At that point, its shares trade on the New York Stock Exchange or NASDAQ.  (Source: thebalance.com)

Summary

Small-cap stocks should not be viewed as low-quality investments. On the contrary, small-cap stocks may provide investors with an opportunity to earn a substantial return on their investments. However, this type of investing should be approached with caution as small-cap stocks are often risky and volatile.  A bit of research can pay large dividends by uncovering undervalued stocks with great growth potential ahead.

Up next:  What is a Stop Limit Order? Limit Orders Explained (Definition and Examples)

What is a stop limit order? It is a conditional trade that combines the features of a stop with those of a limit order and is used to mitigate risk. It is related to other order types, including limit orders (an order to either buy or sell a specified number of shares at a given price or better) and stop-on-quote orders (an order to either buy or sell a security after its price has surpassed a specified point).

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