What is a Small-Cap Stock?
A small-cap stock refers to the stock of a public company with a total market value, or market capitalization, between $250 million and $2 billion. Small-cap stock investors often target emerging companies with high growth potential, essentially seeking future large-cap leaders.
Key Takeaways
- A small-cap stock belongs to a company with a market capitalization ranging from $300 million to $2 billion.
- Investors in small-cap stocks focus on opportunities for growth, often circumventing the efforts of major institutional investors.
- Historically, small-cap stocks have outperformed large-cap stocks but come with higher volatility and risk.
Decoding Small-Cap Stocks
The ‘cap’ in small-cap stands for capitalization, fully referred to as market capitalization. This metric represents the stock market’s valuation of a company’s outstanding shares, calculated by multiplying the current share price by the total number of outstanding shares.
Classifications such as ’large-cap’ and ‘small-cap’ are not fixed and can evolve over time. They may also differ among brokers. A common misconception is that small-cap stocks are startups or new companies. In reality, many small-cap stocks belong to established businesses with robust financial histories and substantial growth potential due to their relatively smaller size.
Comparing Small-Cap and Large-Cap Stocks
Generally, small-cap companies offer more growth room but are associated with higher risk and volatility compared to large-cap companies. Companies like General Electric and Coca-Cola represent large-cap stocks with market capitalizations of $10 billion or higher. These companies provide stability and dividends but often lack the aggressive growth that small-cap stocks can deliver.
Historically, small-cap stocks have outpaced large-cap stocks. However, performance can vary based on the economic climate. For instance, during the tech bubble of the 1990s, large-cap stocks thrived, but small-cap stocks gained prominence after the bubble burst in March 2000.
Investing in small-cap stocks offers the chance to outmaneuver institutional investors due to regulatory restrictions that limit mutual funds’ ownership in small-cap companies. This allows individual investors to capitalize on growth opportunities that are often off-limits to larger funds.
Small-Cap vs. Mid-Cap and Penny Stocks
Mid-Cap Stocks: Serving as a middle ground, mid-cap stocks (market capitalizations between $2 billion and $10 billion) offer more stability than small-caps while retaining significant growth potential.
Penny Stocks: Although both categories include lower-value stocks, penny stocks are specifically those priced below $5. These high-risk investments often trade outside major stock exchanges, unlike small-cap stocks which can have higher share prices.
Advantages and Disadvantages of Small-Cap Stocks
Pros
- High Growth Potential: Small companies have higher growth prospects compared to large-cap companies.
- Lower Share Price: Affordable entry prices make them attractive for individual investors.
- Diverse Options: Small-cap stocks span various industries and often represent longstanding companies, not just startups.
- Under-the-Radar Value: Lesser popularity can translate into undervalued stock prices, offering substantial returns on investment.
Cons
- Price Volatility: Smaller size makes them more susceptible to market volatility, leading to significant price swings.
- Higher Risk: The possibility of failure is greater, with more sensitivity to economic shifts and limited access to capital.
- Less Information: They receive less coverage from analysts, necessitating detailed personal research.
- Lower Liquidity: Buying and selling these stocks can be challenging due to limited demand.
Investing Wisely in Small-Cap Stocks
If you have the time and expertise to research individual stocks, purchase them via a brokerage account after analyzing:
- Earnings and Revenue Growth: Look for growing companies, even if not currently profitable.
- Price-to-Earnings Ratio (P/E): Compare share price to earnings per share to assess valuation.
- Price-to-Sales Ratio (P/S): Useful for assessing non-profitable companies by comparing sales performance.
Alternatively, consider small-cap mutual funds or exchange-traded funds (ETFs) for diversified exposure with reduced individual risk.
Leading Small-Cap Stock Indexes
Two primary indexes track the performance of small-cap stocks:
The Russell 2000
The Russell 2000 index includes the 2000 smallest companies in the broader Russell 3000, offering comprehensive insights into the small-cap market. It is heavily weighted by financials, industrials, and healthcare sectors.
S&P 600
The S&P SmallCap 600 Index consists of 600 companies meeting specific criteria, including positive earnings, to enhance stock quality and reduce volatility. The companies represented account for nearly 3% of the U.S. market.
Conclusion: Are Small-Cap Stocks Worth the Investment?
Small-cap stocks can be a valuable addition to your investment portfolio. They promise substantial growth potential over the long term but come with additional risk and volatility. A thorough analysis of their fundamentals is crucial to identify promising investments, balancing high returns with possible market fluctuations.
Investors should carefully evaluate each opportunity to make informed decisions, taking advantage of the unique potential that small-cap stocks offer in the dynamic landscape of the stock market.
Related Terms: large-cap stocks, mid-cap stocks, penny stocks, micro-cap stocks, stock market index.
References
- Long Term Trends. “Large-Cap vs. Small-Cap Stocks”.
- Library of Congress. “Investment Company Act of 1940”.
- FTSE Russell. “Russell 2000 Factsheet”, Page 2.
- S&P Global. “S&P Small Cap 600”, Page 2.
