What is Small Cap vs. Mid Cap?
Small cap vs. mid cap: As companies get bigger, so do its market capitalization. While we only tend to hear about companies that IPO with massive market caps, many more enter the public markets as small or mid cap companies. And while the distinction between them might seem trivial, it often plays a big role in how investors approach these companies.
Let’s dive deeper into the difference between small cap vs. mid cap, and the pros and cons of investing in these companies.
A Closer Look at Small Cap vs. Mid Cap Stocks
Small caps, by general definition, are those with a market capitalization of between $300 million and $2 billion. They’re generally tested and unproven in public markets. Nevertheless, many have a clear path to larger market capitalization and the business model to take them there. They come to the public markets to access capital that’ll help them make investments in their growth.
Investors can open a position in small cap companies the same as they would any other public security. Many also choose to invest in small cap stocks through indices, ETFs and mutual funds. As of November 2021, there are more than 1,677 small cap stocks, by definition.
As they mature into larger companies, small cap stocks become mid cap stocks. These are companies with a market capitalization of between $2 and $10 billion. They’re seen as companies that have a proven business model, yet are still growing to support potential revenue streams. They’re in growth mode, snapping up market share and generating cash flow that continues to support reinvestment and business growth.
Mid cap stocks tend to garner more attention from investors because they have momentum. They’ve broken out of the volatile small cap phase and have a history that investors can evaluate. They also gain more traction among investors since they’re included in more funds. As of November 2021, mid caps represent about 25% of all publicly traded companies.
Now let’s take a closer look at the benefits of small cap vs. mid cap stocks.
Benefits of Small Caps
- Significant growth potential over time
- Likely undervalued by the market
- Lack of institutional interest to drive up prices
- Volatility offers day and swing trading opportunities
- Potential for merger or acquisition
Benefits of Mid Caps
- High potential for price appreciation
- Proven business model within the market
- Balance of growth and stability
- Better liquidity due to investor attention
- More established financials
Drawbacks of Small Cap vs. Mid Cap Stocks
Drawbacks of Small Caps
- High volatility that’s often unpredictable
- Less transparency in financial reporting
- Less liquidity due to lower volume
- Time-consuming to vet and investigate
- Potential to flounder due to an unproven model
Drawbacks of Mid Caps
- Still susceptible to cash flow struggles
- Could struggle with debt during growth periods
- Lack of institutional investor interest
- Less stable in bearish markets than large caps
- Still working to diversify revenue streams
Keep reading for more information on small cap vs. mid cap stocks.
Consider Your Appetite for Risk
Compared to large- and mega-cap companies, small and mid cap companies are riskier. They’re more affected by market- and sector-wide headwinds and tend to struggle in ways that bigger companies simply don’t need to worry about. Investors who seek to capitalize on the long-term potential of small and mid cap companies need to be okay with the risk they carry.
Indices and ETFs are great ways to hedge against the volatility of smaller companies; however, they also temper returns. Direct investment in single companies expands the potential for risk, but amplifies return on those capable of continued growth. It’s up to investors to select the mode of investment that reflects their risk tolerance concerning small and mid cap stocks.
Be Aware of Growth Stages and Cycles
One often-overlooked factor in small and mid cap investing is the impact of growth on the business model. While growth inevitably pushes up the share price, investors also need to understand how it affects the company’s financials and what that looks like during the transition to a larger market capitalization.
For example, mid cap companies tend to bring on more debt, which can anchor the balance sheet for a period. The mid cap’s proven business model and healthy cash flows give it access to financing previously unavailable to a small cap company. As a result, its debt-to-equity ratio may be somewhat unappealing as it finances growth.
In another example, small caps may not show any revenues when, in fact, they are profitable. Growth hacking small caps will reinvest every single dollar back into the company as a play to get bigger, faster. While it may look like the company has profitability issues on paper, it might actually be a healthy, thriving business that’s quickly moving into a bigger market capitalization.
Be mindful of context when evaluating small vs. mid cap companies. Growth is good! While it might seem like the company is struggling, awareness of growth stages and cycles can clue you in to a promising company that’s about to get bigger.
Seek Out Stable Companies That’ll Get Bigger
When evaluating the similarities and differences between small cap vs. mid cap stocks, it’s important to understand the risks and rewards. Whether you embrace the risk of small caps or look for the proven model of a mid cap company, what matters is the direction that particular stock is trending. A small cap on track to reach mid-market capitalization represents a healthy company. However, a company falling into mid cap range after years spent in large cap territory sends bad signals.
For more info on small cap and mid cap stocks, sign up for the Liberty Through Wealth e-letter below. The Oxford Club’s Chief Investment Strategist, Alexander Green, delivers some of the most remarkable investment insights you will find. Sign up today!
Small and mid cap companies both represent significant portions of the broader stock market. Within these segments are opportunities to invest in fledgling companies that could be the next large- and mega-cap companies of tomorrow. Investors with the patience to identify and evaluate these prospects—and to open a position in them—stand to profit in the future.