What Are Small-Cap Stocks?

Today, let’s talk about small-cap stocks — the “little engines that could” of the investing world. These companies might not have the flashy reputations of big-name giants like Apple or Amazon, but small-cap stocks are potentially one of the most profitable corners of the investment markets. They’re packed with potential and could be the secret weapon your portfolio’s been waiting for.

By definition, they’re the shares of publicly traded companies with a market capitalization between roughly $300 million and $2 billion. “Small” is kind of a relative term when we’re talking in dollars, I guess.

But despite their small relative size, these companies have the potential to deliver outsized growth as they expand, possibly becoming the large-cap companies of the future. So it’s important for retail investors to pay attention to this market and maintain some exposure to the best small-cap stocks.

But in order to answer the question “What are small-cap stocks?” we’ve got to go a little bit deeper than just a market capitalization range. Because more than the size, it’s the structure and stage of these companies that sets them and their investors up for the biggest gains.

Not Yet a Titan, No Longer a Startup

While small-cap companies aren’t necessarily startups, they are generally younger and faster-growing than larger companies. This means that they’re often under-researched by analysts, which can lead to mispricing, creating opportunities for savvy investors.

You can kind of think of them as the awkward-but-promising teenagers of the business world — not quite startups, but not yet the big leagues either. They’re at that sweet spot where they’re old enough to have some stability but young enough to have serious growth potential.

Why Should You Care About Small Caps?

And just like all of us as we went through those awkward years, small-cap stocks can offer a whole lot more than meets the eye:

• Diversification Done Right: Small-cap stocks, like teenagers, tend to march to the beat of their own drum. This means they tend to have lower correlation with large-cap stocks (their prices don’t move in the same direction at the same time). This diversification can help to improve overall portfolio efficiency by reducing risk and potentially boosting returns.
  
  
• Turbocharged Growth Potential: Just like teenagers, small-cap stocks are still growing. As younger companies, small caps often have higher growth potential than larger, more established companies. This growth can translate into significant returns for investors who are willing to hold these stocks for the long term.
  
  
• More Choices = More Opportunities: The small-cap universe is huge. In the U.S. alone, there are around 2,000 small-cap companies to choose from, spanning every sector and industry you can think of. This means more ways to find that hidden gem that aligns with your investment goals.
  
  
• More Inefficiencies = More Opportunities: Remember, we said that small-cap stocks are often under-researched. And the inefficiencies that can cause create opportunities for savvy investors to beat the market. It’s these investors who often identify promising companies that may be overlooked by the broader market.
  
  
• Expanded Opportunity Set: The small-cap universe is vast, offering investors a much wider range of companies to choose from than the large-cap market. In the U.S. alone, there are over 2,000 small-cap companies listed on public exchanges.

Higher Rewards Come With Higher Risks

While the early stage of small-cap stocks offers a number of potential advantages, it is important to remember that youth and inexperience also leads to some risks. So, before you dive in, it’s only fair to examine the flip side of the equation:

• Volatility: Small-cap stocks can be more volatile than large-cap stocks, meaning their prices can fluctuate more dramatically in the short term. This volatility can be unsettling for some investors, but it also creates opportunities to buy stocks at a discount during market downturns.
  
  
• Liquidity Risk: Small-cap stocks often have lower trading volumes than large-cap stocks, which can make it more difficult to buy or sell shares at a desired price. This liquidity risk can be especially problematic during periods of market stress.
  
  
• Information Risk: Due to a lack of analyst coverage, there is generally less information available about small-cap companies than larger companies. This can make it more difficult for investors to assess the financial health and growth prospects of these companies.

Despite these risks, a modest allocation to small-cap stocks can be an extremely valuable addition to any portfolio. Especially for patient, long-term investors, the potential rewards of investing in small-cap stocks almost always outweigh the risks.

Buy a Few or Buy Them All

When considering investing in small-cap stocks, there are a couple of options:

1. Pick Your Favorites: You can invest in individual small-cap companies by purchasing shares through a brokerage account. However, this requires careful research and analysis to identify companies with strong growth potential. Factors to consider include earnings and revenue growth, price-to-earnings ratio, and price-to-sales ratio.
   
   
2. Hire a Professional: You can also invest in small-cap companies through mutual funds or exchange-traded funds (ETFs). These funds offer diversification and professional management, which can be especially beneficial for investors who are new to small-cap investing. Some popular small-cap indexes include the Russell 2000 and the S&P SmallCap 600.

The Bottom Line: Are Small Caps Right for You?

Ultimately, the decision of whether or not to invest in small-cap stocks depends on an individual’s investment goals, risk tolerance, and time horizon.

But if you’re looking for growth and don’t mind taking on a bit of risk, small-cap stocks could be the MVP of your portfolio.

They’re not for everyone, but for those with patience and a long-term mindset, the destination can heavily outweigh the bumps along the road.

Next week, we’ll cover a few of the best resources around the web for top notch small-cap stocks and more. So make sure you stay tuned.