Small cap stocks represent one of the more dynamic asset classes available. That means they are something any growth-oriented investor should know about, but it also means they carry a heightened level of risk.
Investing in smaller companies gives you a chance to catch a rising star. However, since many small companies fail and very few go on to become the next big thing, it's important to understand the risks as well as the return potential.
This article introduces the basics of investing in small cap stocks, including:
- What "capitalization" means
- Defining low cap stocks
- Benefits and risks of investing in small cap stocks
- Approaches to buying small cap stocks
What Does Stock Capitalization Mean?
The "cap" in "small cap" isn't referring to headwear. In this context, "cap" is short for "capitalization."
The market capitalization of a particular stock is the current total value of all that company's publicly traded shares.
For example, if a stock is selling for $40 a share and has 250 million publicly traded shares, its market cap would equal $40 times 250 million, or $10 billion.
"Capitalization" indicates what the marketplace feels a company is worth. It also indicates how much of a stock is available to be bought or sold, which can affect how efficient it is to trade the stock.
What is a Small Cap Stock?
Since market capitalization is a measure of a company's total value, a small cap stock is a company which is considered relatively small.
Note that companies have to be fairly well established to trade publicly in the first place. So a small cap stock is not a small company in the sense that your local bakery or coffee shop is. A small cap stock is large enough to be publicly traded but is smaller than the largest and most prominent publicly traded companies.
A common rule of thumb is to define small cap stocks as those with a capitalization of between $300 million and $2 billion.
How the Russell 2000 Index defines small cap stocks
Another method (which is used to compile the popular Russell 2000 Index of small cap stocks) defines small cap stocks in a different way. This starts with ranking all the stocks traded in the United States by size.
The top tier of these companies are considered large cap stocks. Those that rank below the top tier are considered small cap stocks.
This use of relative sizes does a better job than using a hard-and-fast dollar limit to define small cap stocks because the absolute level of market valuations changes over time.
Other capitalization categories
There are also sub-categories such as mid cap and micro cap stocks. Mid cap stocks are those with a market capitalization between those of large cap and small cap stocks. This category might partially overlap those bigger and smaller categories.
Micro cap stocks are those that are so small they have a capitalization below even that of small cap stocks.
Note that these classifications are most commonly used in reference to U.S. stocks, but there are also large and small cap stocks in other countries. However, the definition of what is considered a large cap or small cap stock on another country's exchange may vary according to range of company sizes represented on that exchange.
Small Cap Stocks vs. Penny Stocks
Another term that is associated with small companies is "penny stock," but penny stocks are a subset of small cap stocks which entail added risks.
A penny stock used to be any stock selling for less than a dollar a share, but this definition has been updated over the years due to inflation so that now stocks selling for less than $5 a share are considered penny stocks.
Such an ultra-low price is generally a sign of low demand for a stock, and that's what adds to the risk of penny stocks. They generally trade on over-the-counter markets and have relatively infrequent transactions.
Those infrequent transactions may make it difficult to sell the stock when you want to. It can also mean there is a wide spread between what sellers ask for the stock and the price buyers are bidding for it. That wide spread can add significantly to the cost of trading.
Stocks that are thinly traded are more open to price-manipulation scams. This is because, when a stock doesn't trade much, even a relatively small amount of activity can move its price substantially. With a little false information, a scammer can profit from a short-term move up or down in a penny stock, which may come at your expense.
There are plenty of small cap stocks that are not penny stocks. So you can easily buy small cap stocks without taking the extra risk of penny stocks.
On the Way Up or On the Way Down?
Small cap stocks are generally associated with young, dynamic companies which may be on their way up. However, this is not always the case.
A company may have a low capitalization because it has fallen out of favor. When evaluating small cap stocks, it is important to make the distinction between up-and-coming companies with strong growth potential and companies that are struggling.
In particular, be wary of stocks with the letter Q attached to the end of their stock symbols. That indicates that the company is in the midst of bankruptcy proceedings.
Why Invest in Small Cap Stocks?
Why do some investors seek out small cap stocks?
One reason is that smaller companies generally have more growth potential than larger companies. Even very successful companies find it hard to sustain the high growth rates of their early years.
Also, large established companies are very well known and closely followed by investors. Their prices generally already reflect their success, so it can be tough to find great bargains among large cap stocks.
Small cap stocks may not be quite as closely followed, and in many cases their products and business models are still evolving. You may be more likely to find an under-the-radar bargain among small cap stocks.
Why Are Small Cap Stocks Riskier?
Along with the growth potential of small cap stocks comes some higher risks.
Small cap stocks are prone to wider swings up and down than large cap stocks. This can look good when things are going well but can be jarring when things turn downward.
In particular, if you don't have a long investment time horizon, you may not be able to ride out a sharp downturn in small cap stocks.
Small cap stocks are often younger companies. These may not have fully developed their business models yet and may not even be profitable. While that can make the potential upside greater, the simple truth is that not all of these companies are going to succeed.
Also, small cap stocks may be more thinly traded than large cap stocks. This can add to trading costs and can make them difficult to get out of at a fair price when there are a lot of people trying to sell.
How to Invest in Small Cap Stocks
If you decide you want to take on the risk of investing in small cap stocks, there are a few ways to approach it. The following are examples of strategies you can take toward small cap investing.
You can pick small cap stocks one by one, focusing on those which look especially promising.
This entails doing fundamental research. You should look into the details of the company you are interested in and also consider their competition and the demand for their products or services.
Consider the share price too. If it's well known that a company has great potential, its price may already be too high for subsequent investors to gain much of a profit.
Based on your analysis, you should compare the future earning potential of a stock with its price to see if it represents a good value.
A diversified approach
Picking stocks one by one involves intensive research. It also leaves you open to the risk that some of those picks might not pan out.
Another way to approach small cap investing is to participate in that market segment more broadly.
Several mutual funds specialize in small cap investing and are widely available from online brokers and mutual fund companies. These mutual funds may seek to follow a market index of small cap stocks or they may use specific selection criteria for choosing small cap stocks.
Either way, buying small cap stocks in large groups can be an efficient approach to getting broad participation in this market segment. It means you won't have the spectacular success of picking a small cap stock that grows to be a giant, but it also limits the risk of individual picks being wrong.
Fit with other investments
You don't have to view small cap investing as an all-or-nothing deal. Often small cap stocks are used as a portion of portfolio designed to work alongside a range of different investments.
Small cap stocks can represent a "higher risk/higher return" potential segment of your portfolio. You can use large cap stocks, bonds, cash equivalents and other investments somewhat to balance out the risk of small cap stocks.
You can come up with a mix of investments yourself to see how big a role you want small cap stocks to play or you can use a robo-advisor to come up with a target asset mix for you.
In short, there is more than one way to invest in small cap stocks. Understanding the potential benefits and risks of this segment of the stock market should help you decide which approach best fits your needs.
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