Did you know that 35% of the entire stock market is made up of small-cap stocks?
If you’ve ever wished you could invest in the next Apple, small-cap stocks are an excellent choice to add to your portfolio. These companies are small enough to be ignored by investors but have a higher growth potential than large companies.
In fact, the average small-cap value stock has significantly outperformed the average large-cap growth stock since 1926.
Unfortunately, the media only focuses on the negative side of investing in small-cap companies. They say that investing in small-cap stocks is too risky. You’ll also hear small-cap stocks dubbed low quality compared to the more prominent players.
While small-cap stocks are indeed riskier than large-cap stocks, they also have many upsides that make them a great choice for individual investors. In this post, we’ll take a deep dive into small-cap stocks and why you should invest in them.
What are Small Cap Companies?
To understand small-cap stocks, you’ll first need to learn about market capitalization.
Market capitalization, abbreviated to “market cap,” is the market value of a publicly-traded company. It’s the total value of a company’s outstanding stock, calculated by multiplying the total number of shares by the current share price.
Market Cap = Total No. of Shares x Share Price
Market capitalization is generally used to classify stocks into three categories based on size: large, mid, and small caps.
A large-capitalization company has a market cap of over $10 billion. A mid-cap company has a market capitalization of between $2 billion and $10 billion, and a small-cap company has less than $2 billion in market capitalization.
Generally, small-cap companies have a market capitalization of between $300 million and $2 billion. Companies that fall below the $300 million market capitalization range are called micro caps. Some of the features of small-cap companies are:
- They are smaller in size
- They have a market cap of between $300 million and $2 billion
- They have substantial growth potential
- There’s always a high risk-return trade-off associated with them
- Small-cap stocks can become multi-baggers in the future
By definition, small caps stocks are issued by smaller companies. You can find them in virtually any stock market sector, including tech, finance, healthcare, and hospitality.
Why Invest in Small-Cap Stocks?
Small-cap stocks offer opportunities for investors to create wealth.
And because they’re from smaller companies, these stocks have more room for growth. If you pick the right company to invest in and hold on to its stock long-term, you could make more money than you would with large caps.
However, large caps are usually less risky than small-cap stocks. Here are a few advantages to investing in small-cap stocks.
1. High Potential for Growth
The thing with small caps is that they give investors a chance to get in on the ground floor.
These smaller companies are innovating every day, bringing in new products and services to the market, which in turn foster growth. And when a small-cap is performing, its stocks can jump 10%, 15%, or more in a day.
And because most small caps are still in the infancy or growth stage, they can expand in ways that larger companies can’t. The under-researched and under-owned nature of smaller companies give them broader scope to expand in the future.
For instance, a large company with a market cap of $1 trillion doesn’t have the same growth potential as a company with a $500 million market cap.
A company like Amazon is practically not competing with anyone. The company has nearly reached its zenith, and it can’t grow exponentially since it can’t be bigger than the entire economy. In contrast, small caps are always looking for new ways to diversify, expand, and dominate the market, hence have a higher potential for growth.
From an investor’s standpoint, there are opportunities to grow with the company by buying and holding the shares when the company is still small.
As Warren Buffet inferred, even the world’s most successful investors are attracted to small-cap stocks. Buffet might not invest in small caps today. But he did so in 1972 when he bought See’s Candies for $25 million—a company that changed his investment style for good.
2. Quality Stocks at Low Prices
Generally, due to the high demand, large-cap stocks may be overvalued since individuals and institutional investors are largely investing in them, thereby pushing the prices up.
In contrast, shares for smaller companies are easily available at a discounted price. This makes it easy for individual investors to invest in them using limited funds.
Plus, small-cap stocks are sometimes undervalued due to possible inefficiencies in the market. Hence, with some research and market evaluation, investors can benefit from acquiring such quality stocks at low prices.
3. Potential to Maximize Returns
One of the top reasons to invest in small-cap companies is their greater potential to yield better returns than larger players.
For instance, it’s a lot easier for a $500 million company to become a $1 billion company than a $1 billion company to grow to $1 trillion. Small-cap stocks tend to have a higher growth rate and earning potential.
That said, it’s easier for a small-cap company to double its revenue than a big-cap company. And revenue growth often results in stock prices moving up.
However, smaller companies are also likely to be unprofitable. This makes them more volatile than larger companies as they’re more vulnerable to recessions and other economic downturns. Hence, small caps are riskier than large-cap companies.
4. Can Help to Diversify
Adding small caps to your portfolio provides diversification from larger players while keeping you safe from international risk since they tend to be domestic companies.
Small-cap stocks add balance to a portfolio, especially for investors who are heavily weighted in niche markets. Diversifying spreads your investment across many companies, diminishing your losses in the event of one company failing.
Investing in small-cap stocks poised for growth can deliver big gains and improve the total return for your overall investment portfolio. Small-cap stocks are also a great way to diversify and minimize the inherent risks associated with these stocks.
On the downside, small-cap stocks are highly volatile, making them riskier than large-cap stocks. And because of the smaller pool of investors interested in these companies, small-cap stocks can be less liquid or harder to sell.