If you’ve seen any news about the stock market this month, it’s likely you’ve come across headlines about the small-cap sector and a rotation away from large-cap stocks. If this recently sleepy sector isn’t completely familiar to you, that makes sense; small-cap stocks have been out of the spotlight for a few years, so it stands to reason that many successful investors don’t even know what the fuss is all about. The following is intended to fill in the gaps and answer questions for both the veteran investor and the newbie.
What are Small-Cap Stocks?
A generally accepted definition of small-cap stocks is those with a market capitalization of between $250 million and $2 billion. Market cap, very simply, is determined by taking the amount of all the shares outstanding and multiplying it by the current market price. This constantly adjusting amount equals the company’s total capitalization. Small companies are, on average, younger entities, with many in the growth stage of the corporate lifecycle.
This means that, as a whole, they offer more potential than older household names, and investors in this sector know that proper selection can unearth the next Tesla (TSLA).
Risk and Reward: Small-Cap vs. Large-Cap Stocks
While small-cap stocks offer the potential for high growth, they also come with increased risk. Compared to large-cap stocks, they are more volatile, meaning their prices can fluctuate more dramatically. This volatility can be nerve-wracking for some investors and may not be suitable for those who may need access to their assets soon. Nevertheless, it presents opportunities for those who can ride out a choppier path, hopefully to new highs. Interestingly, small caps have historically outperformed large caps over time.
However, one important factor to consider when investing in small-cap stocks is the company’s trading volume or the number of shares traded daily. Lower trading volume can lead to lower liquidity, making it difficult to buy or sell shares quickly without affecting the price.
Advantages of Small-Cap Stocks
For investors with a higher risk tolerance and a longer-term perspective, the advantages of allocating money to small caps could make sense. Investments could be made by buying ETFs or by picking what you think may be the next stock to skyrocket. We’ll talk about indexes and stock picking later, but for now, here are some advantages to investing in small caps:
- High Growth Potential – Small-cap companies are often in high-growth industries with the potential to experience significant stock price appreciation.
- Lower Share Prices – Compared to large-cap stocks, small-cap stocks tend to have lower share prices, making them more affordable for individual investors.
- Diversification – Small-cap stocks react differently, so they can add diversification to your portfolio, reducing your overall risk.
Disadvantages of Small-Cap Stocks
Smaller companies don’t have the resources that larger companies do. Therefore they can be seen as at greater risk. For example, a large company like IBM (IBM) can fulfill a funding shortfall by issuing bonds, while smaller companies are more reliant on the equity markets to raise necessary funds. By issuing any new shares that were not available to the public before, the value of the previously existing shares will be diluted, essentially lowering their value. Some more disadvantages to consider include:
- Volatility – As mentioned earlier, small-cap stocks are more volatile than large-cap stocks. This means their prices can swing more widely in a short period of time.
- Higher Risk – Small-cap companies are more likely to fail than large-cap companies. This means there’s a greater chance that your investment could lose value.
- Less Information Available – There is typically less publicly available information about small-cap companies compared to large-cap companies. This can make it more difficult to research and assess these investments.
- Lower Liquidity – As discussed earlier, lower trading volume can lead to lower liquidity, making it difficult to buy or sell shares quickly without affecting the price.
Popular Small-Cap Stock Indexes
There are two main indexes that track the performance of small-cap stocks in the U.S. The most quoted is the Russell 2000 (IWM). This index tracks the performance of the bottom 2,000 of the 3000 largest companies in the U.S. as determined by the FTSE Russell Indexes. The second most quoted small-cap index is the S&P 600 (SPSM). This index tracks the performance of the 600 smallest companies in the S&P 1500 Index.
Stock Pickers Paradise
The small-cap sector is viewed as a stockpicker’s paradise. It includes every industry and typically has share prices below $10. And since the companies are less likely to be discussed on news shows as often as mainstream companies are, research is critical. Most brokerage services have rudimentary screening tools to begin a search.
The robust Stock Screening Tool online at TipRanks allows the user to sort a universe of stocks by market cap, isolating small-caps by choosing the drop-down “Small 250m-2b” for small-cap results. Investors can then sort by trading volume before exploring other data, such as Wall Street analyst expectations and a long list of other filters.
Key Takeaways
Small-cap stocks are back in the spotlight as investors are once again finding value in this sector. One should not commit too much capital to that which they have little understanding. However, with added understanding, small-cap stocks can be an informed way to add growth potential and diversification to an investment portfolio. Remember, low-volume stocks will be difficult to move in and out of when needed. Tools such as those found on the TipRanks platform can make a big difference in identifying your next target.
