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Small Cap Stocks: Definition and Pros & Cons

Rebecca Lake
Should you invest in a small cap stock?

Small cap stocks are one type of stock investment you can hold in your portfolio. These stocks differ from large cap and mid cap stocks in several key ways. There are several advantages associated with investing in smaller companies, along with a few drawbacks to keep in mind. If you’re contemplating adding small cap stocks to your investment strategy, here’s a breakdown of what they are and how they work.

What Is a Small Cap Stock?

The term “small cap” is used to identify stocks that have a market capitalization of between $300 million and $2 billion. Market capitalization or market cap means the total value of a company’s outstanding stock shares. It’s calculated by multiplying the total number of shares issued by the market price of a single share.

By comparison, mid cap stocks have a market cap ranging from $2 billion to $10 billion, while large cap stocks surpass the $10 billion mark. Companies that fall below the $300 million market cap range are known as micro caps.

By definition, small cap stocks are issued by smaller companies. You can find small caps in virtually any stock market sector, including healthcare, finance and tech. Some examples of small cap companies include Papa John’s (PZZA), Redfin (RDFN) and Axos Financial (AX).

Like large and mid cap stocks, small caps have their own index. The Russell 2000 Index tracks the performance of 2,000 small cap U.S. companies, excluding stocks that trade for under $1 per share. The index can be used as a helpful benchmarking tool for investors when determining which small cap stocks to invest in.

Advantages of Small Cap Investing

Should you invest in a small cap stock?

There are some good reasons to consider incorporating small caps into your portfolio. These details below set them apart from mid and larger cap stocks.

1. High Growth Potential

With large cap companies, growth potential is limited. Companies like Facebook (FB) or Amazon (AMZN), which have seen exponential growth, may have a lower ceiling for realizing additional rise in share values. A smaller company, on the other hand, may have years of growth and price appreciation still to come.

From an investor perspective, that means there are opportunities to get in on the ground floor with an up-and-coming company. Buying and holding shares when the company is still small could pay off if it grows and share prices increase in value. If the company does well, it could eventually move from small cap to large cap status.

2. Less Competition From Institutional Investors

Institutional investors include banks, hedge funds and real estate investment trusts. These are entities that pool money to invest on the behalf of individual investors.

Small caps are often overlooked by bigger institutional investors because of their size. Additionally, federal regulations block them from investing heavily in small caps. That leaves the door open for smaller investors to buy in with the hope of seeing a smaller company grow over time.

3. Better Returns Compared to Large Caps

Large cap companies can offer investors stable returns and, in the case of dividend-producing stocks, income. Small caps, on the other hand, may not produce dividends but they’ve historically outperformed larger companies when it comes to average annual returns.

Aside from having greater growth potential, smaller companies can be more agile than their larger counterparts, which can make it easier to adjust to changes in the stock market cycle, develop and launch new products or services, or undergo an internal restructuring if necessary. All of this can add up to small caps being able to offer better performance within their market niche, compared to bigger competitors.

Risks of Trading Smaller Companies

No investment is foolproof and small cap stocks are no different. In terms of downsides, there are a few things to keep in sight when considering an investment.

1. Volatility May be Higher

It’s not abnormal to get a little seasick when stock prices change rapidly. By nature, smaller companies tend to be less insulated from volatility compared to bigger companies because of their shorter track record. If a smaller company has less access to investment capital, or it’s still fleshing out its business model, it can potentially become more volatile. This is something to be aware of if you don’t necessarily have the stomach for riding out wide pricing swings.

2. Limited Liquidity

Liquidity means how easily you’re able to buy and sell shares of a particular security. Compared to larger companies, small cap stocks tend to be less liquid because of their size. When a company isn’t as well-known, you may find fewer people who own shares to buy from. Vice versa, there may be fewer buyers on the market when you’re ready to sell, compared to a mid or large cap holding.

3. Less Transparency

Before buying any stock it’s important to do some digging and learn more about its fundamentals. The challenge with small caps is that there tends to be less information to inform your investment decisions. For example, you may not have several decades’ worth of earnings reports or pricing trends to review. This could make it a little harder to evaluate a small cap’s potential.

How to Invest in Small Cap Stocks

Should you invest in a small cap stock?

You can purchase individual small cap stocks through a taxable brokerage account. Another option is investing in mutual funds, index funds and exchange-traded funds (ETFs) that have a small company focus.

Evaluating small caps means looking at some key metrics, including the ones below.

  • Earnings and revenue growth: Checking year-over-year earnings and revenue growth can help you gauge a small cap’s trajectory. Remember, the company may not be profitable yet, but if earnings and revenue are growing steadily, it’s a sign that it’s moving in the right direction.
  • Earnings per share: This calculation refers to a company’s profit, divided by the number of shares of outstanding common stock. You may or may not be able to calculate this, based on a small cap’s profitability status.
  • Price-earnings ratio (P/E): The price-earnings ratio is a way to measure a company’s value, based on how current share price compares to earnings per share. A stock with a lower P/E ratio could be undervalued, which could be a bargain-buying opportunity. A higher P/E ratio could hint that the company’s stock is overvalued.
  • Price-sales ratio (P/S): This ratio represents market cap divided by revenue. If a small cap company doesn’t have any earnings per share to report, you can substitute this ratio instead to measure its performance against other small caps.

The Bottom Line

Small cap stocks can help diversify your portfolio. Plus, they may yield better returns if you’re comfortable taking on more risk. Getting to know small cap stocks well, plus their pros and cons, can help you decide where they fit in your investment plan. 

Tips for Investors

  • If you’re trading small caps through an online brokerage account, remember to check the commission fees you’re paying. Trading frequently could take a bite out of your returns if you’re paying a higher fee.
  • Also pay attention to cost if you’re investing in small cap mutual funds through a brokerage account, your 401(k) or an IRA. Specifically, check the fund’s expense ratio so you know what it will cost you to own it annually.
  • Consider talking to an advisor about how to invest in small cap stocks if you’re unsure where to start. Finding the right financial advisor that fits your needs doesn’t have to be hard. SmartAsset’s free tool matches you with financial advisors in your area in five minutes. If you’re ready to be matched with local advisors that will help you achieve your financial goals, get started now.

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