Advantages & Risks of Investing In Small-Cap Stocks

Small-cap companies are businesses with a market value, or market capitalization, between about $250 million to $2 billion. A vast majority of companies fall into the category of small-caps. The aforementioned group of companies generally perform effectively during the initial stages of the economic recovery. Moreover, the stocks they issue are referred to as small-cap stocks.

What Is a Small-Cap Stock?

Stocks of small-cap companies that are issued for public trading on a stock market are referred to as small-cap stocks or small-cap equity. Small-cap companies are an excellent choice for investors who want to obtain greater investment returns. Furthermore, those with higher risk tolerance to market risks can consider this investment.

Due to its volatile nature, these stocks are subjected to market risks whenever the market goes through a downturn. However, by including favorable market investments in their portfolio, investors can minimize the risks connected with small-cap stocks.

The total value of all outstanding stock shares is commonly referred to as a company’s market capitalization or market cap. It is estimated by dividing the total number of shares issued by the market value of the share. Conversely, large-cap stocks possess a market cap exceeding $10 billion, and mid-cap stocks have a market cap of $2 to $10 billion. Microcap companies include those with a market cap under $300 million.

Smaller companies issue small-cap stocks. Furthermore, the stock market’s financial, healthcare, and technology sectors all include small caps. Redfin (RDFN), Axos Financial (AX), and Papa John’s (PZZA) are a few examples of small-cap businesses.

Small-cap businesses have an index similar to large and mid-cap stocks. Apart from the stocks that trade for less than $1 per share, the Russell 2000 Index tracks the performance of 2,000 small-cap U.S. companies. Investors can use the index as a valuable benchmarking tool when considering which small-cap stocks to place their money in.

Advantages of Small-Cap Investments

You can consider including small caps in your portfolio for many positive reasons. The following differ from mid and large-cap stocks in three significant ways.

Great Potential for Growth

From an investor’s viewpoint, there are plenty of opportunities to make investments early in an emerging company. Investing and holding shares in a small company could benefit financially if that company grows and the stock value increases. If the business works out well, it could ultimately upgrade from a small cap to a large cap.

On the contrary, the potential for growth in large-cap companies is limited. Companies with rapid growth, like Facebook (FB) and Amazon (AMZN), could be subjected to a lower ceiling for potential stock price hikes. On the contrary, a smaller company has the possibility of experiencing growth over the years and possible price growth.

Less Competition from Institutional Investors

Hedge funds, Banks, and real estate investment trusts are a few examples of institutional investors. These companies collect funds for investments on behalf of individual investors.

Given their size, big institutional investors frequently overlook small caps. Moreover, federal laws limit them from making significant investments in small companies. This enables the investors to witness a start-up company flourish over time.

Higher Returns Compared to Large Caps

Large-cap companies can offer investors steady returns, and in the event of stocks that pay dividends, income. Although small-cap companies fail to pay dividends, they have consistently outperformed big companies concerning average annual returns.

Small companies tend to be more flexible than big companies, making it easier to adapt according to the fluctuations in the stock market cycle, create and launch novel products or services, or carry out internal changes if required. Small companies have greater growth potential. Consequently, small-caps could outperform larger competitors in their market as well.

Disadvantages Of Small-Cap Investments

Undoubtedly, investing in small-cap companies offer plenty of opportunities. However, most of them are likely to be of low quality. Before investing in small-cap stocks, investors need to be conscious of the following negative aspects.

Volatility Could Be High

It’s natural to feel worried when stock prices keep fluctuating constantly – this is the reality of small-cap stocks. Given their short histories, small companies are naturally more vulnerable to volatility than big ones. A small company can be more volatile if its access to investment capital is limited or if it is continuing to develop its business plan. If you cannot cope with price fluctuations, be mindful of this!

Constrained Liquidity

The simplicity with which you can buy and sell shares of a specific stock is referred to as liquidity. Given their smaller size, small-cap stocks generally have lower liquidity when compared to big companies. It may be more challenging to find people who have shares to buy from when a company is not widely known. Conversely, similar to a mid or big-cap holding, it may also be challenging to find willing buyers when you decide to sell.

Limited Transparency

Researching and learning more about a stock’s fundamentals is vital before buying it. The problem with investing in small-cap is that there needs to be more information to guide your investment choices. For example, you might not get access to profitability information or pricing trend histories of the company. This could make it hard to determine the potential of a small-cap stock.

How To Invest in Small-Cap Stocks

An individual small-cap stock can be purchased via a taxable brokerage account. Another possibility is to invest the money into index funds, mutual funds, and exchange-traded funds (ETFs), which have a small business focus. Considering multiple significant requirements, such as those presented below, is vital when assessing small caps.

Earnings & Revenue Growth

You can assess the patterns of a small-cap by studying past earnings and revenue growth. Even if the company is not profitable, if its profits and revenues are gradually rising, it could indicate that it is heading in the right direction.

Earnings Per Share

This calculation considers the number of outstanding shares of common stock and divides the company’s profit by that number. Given the profitability of a small cap, you may or may not be able to decide this.

Price-Earnings Ratio (P/E)

The price-earnings ratio is a method to evaluate a company’s value depending on how the current share price compares to earnings per share. Lower P/E ratios suggest that a stock may be undervalued, enabling a bargain-buying opportunity. Meanwhile, a greater P/E ratio indicates that the company’s shares are overvalued.

Price-Sales Ratio (P/S)

The price-sales ratio (P/S) is calculated by dividing the market value by revenue. You can use this ratio to compare the performance of a small-cap company to other small-caps if it fails to provide earnings per share to disclose.

Bottom Line

Conclusively, small-cap stocks can offer prospects for growth that large-cap stocks fail to provide. The success of these companies can lead to substantial long-term gains when combined with a low-cost investment. Since small-cap stock values can be occasionally volatile, they are not the best choice for investors with short or medium-term investing perspectives. Investors should research these stocks thoroughly before taking the plunge because of the lower liquidity and risk involved.