Small-Cap Stocks

What Are Small-Cap Stocks?

Small-capitalisation, or small-cap, stocks are generally considered to be those with a market value of between US$300 million and US$2 billion. Market capitalisation is the price of the company's stock multiplied by the number of shares outstanding.

Small-caps should not be confused with start-ups. Small-caps have generally "graduated" from the start-up phase and have established themselves enough to sell their shares to the public. Many are well-seasoned companies.

Investors can invest directly in the shares of individual small-cap companies or through the many mutual funds and exchange-traded funds (ETFs) that invest in a portfolio of them, which provides diversification and reduces risk.

Small-cap stocks have both positive and negative characteristics that investors should be aware of.

Why Invest In Small-Cap Stocks?

Small-cap companies generally can grow faster than larger companies, especially in percentage terms. This is particularly true at the start of an economic expansion. Small-cap companies contribute about two-thirds of new job growth.[1] That often means their stock prices can grow faster than big-cap stocks.

Small-cap companies can usually make faster decisions than larger companies and thus take advantage of new market opportunities. Big-cap companies have thousands of far-flung employees and multiple layers of management, ultimately reporting to a board of directors at the top, which makes decision-making a slow process. Small companies, by contrast, often have just a handful of decision-makers and can implement new strategies quickly.

Because of their size, small-cap stocks are often ignored or overlooked by large institutional investors. Likewise, big Wall Street investment firms often don't have research analysts that cover small-cap stocks. That creates investment opportunities for investors willing to search out good, under-valued companies.

Small-cap doesn't necessarily mean that a company is in its infancy or recently released from a start-up phase. Many smaller companies have been around a long time and have a strong financial base.

Because of their size and sometimes-limited financial resources, many small-cap companies don't do business outside their home country, which means they're not exposed to foreign currency or political risk like large multinational companies. However, that could cut both ways, as they may miss out on opportunities far from home.

Negatives Of Small-Cap Stocks

Small-cap stocks tend to be more risky than bigger cap stocks. While small-cap companies generally outperform and grow faster during economic recoveries, they are also more vulnerable to economic downturns because they don't have the financial resources that larger companies do to weather bad economic times. That's why many investors choose small-cap mutual funds and ETFs in order to spread the risk.

Because of their size, small-cap companies have fewer shares outstanding. That could create liquidity problems for investors, either because enough shares of a hot company are not available, or it becomes difficult to find buyers if many investors are trying to unload their shares at the same time.

For the same reason that their shares are less liquid and Wall Street research firms ignore them, small-cap stocks can be more difficult for investors to research. Small-cap companies generally don't have large investor relations and marketing departments that provide information about the company. They also don't generate a lot of news coverage.

Small-cap stocks generally don't pay dividends. Small companies need the money instead to invest in their own growth. While many investors in small-cap stocks are more interested in price growth, dividends are an important source of overall investment returns.

Summary

Small-cap stocks are generally considered to be those with a market capitalisation of between US$300 million and US$2 billion. Small-cap companies generally grow faster than their large-cap counterparts, particularly at the beginning of economic expansions. However, they also tend to be more vulnerable during economic downturns. Small-cap stocks therefore tend to be more risky and less liquid than larger companies' stocks.