Understanding Small Cap Stocks
Small cap stocks represent a group of public companies with a long growth runway ahead of them. They’re categorized as more volatile or higher risk than mid or large cap stocks. While more stable than the likes of micro cap stocks, small caps face a variety of headwinds that can make them tricky to invest in. That said, there’s tremendous upside in a small cap stock that represents a well-run, innovative company.
Investors intrigued by small cap stocks need to fully understand the pros and cons of investing in them, as well as what to expect from an investment. Those with the wherewithal to hedge themselves against small cap volatility could end up owning a few gems in their portfolio.
What Are Small Cap Stocks?
Small cap stocks are those with a market capitalization of between $300 million and $2 billion. It may not seem like it, but small cap stocks are the most prevalent group of companies on the market. According to data compiled by Harvard Law School, the median market cap for public companies is $832 million. They may not be the most valuable group, but small caps are the most prolific.
Beyond the numbers, small cap stocks can take many forms. Small regional companies, bootstrapping startups, and family-owned companies are all small cap candidates. Emerging market companies also fall into the small cap camp. Typically, these companies represent the promise of future growth. They’re small now, but they could get a whole lot bigger.
The primary advantage of small cap stock investing is that it’s friendly to retail investors. Institutions such as mutual funds can’t control more than 10% of a company’s voting shares. This prohibits institutions from bulk buying shares. As a result, small caps tend to fly under the radar of big-time investors. They’re a haven for retail investors.
Pricing and valuation are also advantages. Because they’re overlooked by institutional investors, small cap stocks are more prone to market inefficiency. This is great for value investors looking for a deal. There’s also no price manipulation to worry about, since daily trading volume is almost entirely composed of retail investors.
There’s also the benefit of a growth runway. Relative to large cap companies, small companies have higher growth potential. It’s easier to move the needle when you’re worth $300 million than if you were worth $300 billion. New innovations, partnerships, territories, acquisitions, and the like will raise the share price of a small cap company more significantly. Investors who have the confidence to buy in early will capitalize through these growth periods. It all adds up to a prospect of higher returns.
Small caps aren’t all sunshine, rainbows and rockets to the moon. There’s significant risk to consider before investing in young, small and unproven companies.
The first and biggest risk is volatility. Just like good news can move the needle, so can bad news. Small cap stocks suffer mightily from bad news—sometimes disproportionately. Failing to meet earnings projections or having a deal fall through can tank a small cap’s stock price and keep it down.
Small caps also depend heavily on fundamentals as opposed to market sentiment. While large caps can weather bad PR with better-than-expected earnings or a management change, small caps are under the microscope. Good financials, leadership, and social responsibility are vital. Unfortunately, it’s tough for small companies to fire on all cylinders all the time. Setbacks happen and when they do, it can sour investors.
Finally, there’s liquidity to consider. Small caps have a reputation for poor liquidity, and it might not be easy to take profits or unload a losing position. Small cap investors can get frustrated when they, like other investors, want to exit a position and find themselves staring at a high bid-ask spread. You might end up selling at a greater loss or losing out on gains due to low volume.
Real Examples of Small Cap Stocks
As mentioned, there’s a sea of small cap stocks to choose from out there. The problem for many investors is familiarity. You likely haven’t heard of a small cap company unless you’re intimately familiar with it.
Most small caps get noticed on stock screeners or if they make the news in a way that turns up the dial on investor sentiment. Here are a few small cap stocks that have made headlines recently:
- Carparts.com (Nasdaq: PRTS) (Consumer)
- Yext (NYSE: YEXT) (Information Technology)
- XBiotech Inc. (Nasdaq: XBIT) (Healthcare)
- Community Health Systems Inc. (NYSE: CYH) (Healthcare)
These companies are all below the $2 billion threshold for a small cap. That said, they’re gaining steam. It might not be long before they’re well-into mid cap or even large cap territory. In the meantime, a few lucky micro caps might take their place. Or, a few mid cap companies could lose steam and regain small cap status.
Should You Invest in Small Cap Stocks?
Investing in small cap stocks means being able to shoulder more risk. Investors need to tolerate downtrends and temper their expectations on uptrends. While there’s significant growth potential and historical performance associated with small caps, there’s also less transparency. Fundamentals matter much more for small companies: leadership, marketability, financials, etc.
In fact, a small cap company can become a disruptive force in its market, and a huge performer in your portfolio. Poorly run—or faced with hardship, a small cap could be the marathon investment that never seems to cross the finish line. If you’re interested in continuing to learn about small caps, check out this article on small cap ETFs.