Small-Cap Stocks: Definition, Investment Potential, and Risks

What Is a Small-Cap Stock?

A small-cap stock is a stock from a public company whose total market value, or market capitalization, is about $250 million to $2 billion. Small-cap stock investors tend to be looking for up-and-coming young companies with significant growth potential. They're looking for the large-cap stocks of the future.

Small-cap stocks are often overlooked due to less media and institutional coverage; however, they offer unique investment opportunities. Small-cap stocks have more room to grow than large-cap stocks. However, because they lack access to investment capital and are more volatile to market changes, small-cap stocks are riskier than large-cap stocks. Mid-cap stocks offer slightly more stability and also offer more growth potential than large-cap stocks.

Small-Cap Stock Basics: Market Capitalization and Growth Potential

The "cap" in small-cap stands for capitalization. The term in its entirety is market capitalization.

This is the market's current estimate of the total dollar value of a company's outstanding shares. To calculate a company's market capitalization, multiply its current share price by the number of outstanding shares.

Classifications such as "large-cap" or "small-cap" are approximations that change over time. Furthermore, the precise definition of small-cap stocks versus large-cap stocks may vary among brokers.

One misconception about small-cap stocks is that they are startups or brand-new companies. In reality, many small-cap stocks are of companies that are well-established businesses with strong track records and great financials. And because they are smaller, small-cap stock share prices have a greater chance of growth.

Comparing Small-Cap and Large-Cap Stocks: Risks and Opportunities

As a rule, small-cap stock companies offer investors more room for growth but also bring greater risk and volatility than large-cap stock companies.

A large-cap offering has a market capitalization of $10 billion or higher. For large-cap stock companies such as General Electric (GE) and Coca-Cola Co. (KO), aggressive growth may be in the rear-view mirror. Such companies offer investors stability and dividends but rarely fast growth.

That said, whether smaller or larger companies perform better over time varies depending on many factors.

For example, large-cap stock companies dominated during the tech bubble of the 1990s, as investors gravitated toward stocks such as Microsoft (MSFT), Cisco (CSCO), and AOL Time Warner. After the bubble burst in March 2000, small-cap stock companies became the better performers, as many of the large caps hemorrhaged value in the crash.

One advantage of investing in small-cap stocks is the opportunity to beat institutional investors. Many mutual funds have internal rules that restrict them from buying small-cap stock companies. In addition, the Investment Company Act of 1940 prohibits mutual funds from owning more than 10% of a company's voting stock. This makes it difficult for mutual funds to build a meaningful position in small-cap stocks.

Small-Cap vs. Mid-Cap Stocks: Balancing Stability and Growth

Investors who want the best of both worlds might consider mid-cap stocks, which have market capitalizations between $2 billion and $10 billion. Historically, these companies can offer more stability than small-cap stock companies, yet confer more growth potential than large-cap stock companies.

However, for self-directed investors, spending the time to sift through small caps to find a diamond in the rough can prove to be time well spent.  For self-directed investors, taking the time to research small caps can be rewarding. In our data-rich world, many great small-cap investments go unnoticed due to limited analyst coverage.

Distinguishing Small-Cap Stocks from Penny Stocks

Shares in both small-cap stocks and penny stocks have lower market value than large- or mid-cap stocks. Penny stocks have small market capitalizations, so they could be considered small-cap stocks. However, there are specific characteristics that make a stock a penny stock, which not all small-cap stocks share.

Penny stocks have prices under $5, with some traded on the New York Stock Exchange. Most trade directly as over-the-counter or "pink sheets."

Penny stocks are high-risk investments because of their:

• Low price
• Lack of liquidity
• Wide bid-ask spread

Unlike a penny stock, small-cap stocks can have a share price of $5 and higher. They are categorized based on their market capitalization.

Benefits and Drawbacks of Investing in Small-Cap Stocks

Benefits

• Potential for growth: Because these companies are smaller, they have more potential for growth relative to large-cap companies. This means investors in them have the potential to make a large profit.
• Lower share price: The share price of small-cap stocks is often lower, making your initial investment easier. And share prices can't be artificially pushed up by mutual funds or hedge funds, since there are regulations to prevent financial institutions from investing heavily in them.
• Variety of businesses: Small-cap companies aren't only start-ups. They can be found in all industries, and many of them have been in business for a while. This provides a variety of options for investing.
• Less popular: Because there is less popular information about small-cap companies, they aren't as well-known as large- and mid-cap companies. This means they are often priced below their value and can provide a solid return on investment.

Drawbacks

• Volatile prices: Smaller companies react more to volatility in the market because they have less financial cushion than their larger counterparts. As a result, small-cap stocks can see sudden and wide price fluctuations.
• High risk: While small-cap companies have a lot of growth potential, they have equal potential to fail. Small-cap stocks are riskier than large-cap stocks because the companies have less access to investment capital and are more sensitive to market changes.
  
• Less available information: Financial institutions and analysts don't give small-cap companies as much coverage as large- and mid-cap ones. As a result, you need a solid understanding of company valuation and time to do your own research before investing.
• Low liquidity: The smaller size and lower popularity of small-cap companies make their stock less liquid. Lesser-known companies can make it harder to find sellers when buying shares and harder to sell when exiting the market.
  

Guide to Investing in Small-Cap Stocks: Strategies and Tips

If you have time and knowledge, you can research and invest in individual small-cap stocks through a brokerage account. Before investing, check the company's:

• Earnings and revenue growth: Even if a company isn't yet making a profit, you want to see that it is growing and increasing its revenue.
• Price-to-earnings ratio: The P/E ratio compares the current share price to the earnings per share to measure the value of the company's shares.
• Price-to-sales ratio: If the company doesn't yet have any earnings per share, you can use the P/S ratio to measure how it performs compared to other small-cap stocks.

 If researching individual stocks feels too time-consuming or risky, consider small-cap mutual funds or ETFs instead. These might track broad small-cap indexes, specific industries within the small-cap market, or investment goals like value or growth.

Exploring Small-Cap Stock Indexes: Key Benchmarks and Funds

Many brokerages offer small-cap stock index funds, either as mutual funds or as ETFs, to track the U.S. small-cap market. Depending on the brokerage you use, you could, for example, invest in the Vanguard Small-Cap Index Fund (VSMX) or the Fidelity Small Cap Index Fund (FSSNX).

Two main small-cap indexes serve as benchmarks for the small-cap equities market.

The Russell 2000

The Russell 2000 is a small-cap stock market index composed of the 2,000 smallest companies in the Russell 3000. The index is frequently used as a benchmark for measuring the performance of small-cap stock mutual funds. It is managed by London's FTSE Russell Group.

Because it tracks such a broad share of the small-cap market, the Russell 2000 is used by many mutual funds and ETFs. It is heavily weighted by financials, industrials, and healthcare.  

S&P 600

The S&P SmallCap 600 Index was established by Standard & Poor's (the creator of the S&P 500). It uses a capitalization-weighted index to broadly track the performance of small-cap stocks on the U.S. equities market. It includes 600 companies and represents close to 3% of the U.S. market.

Unlike many other small-cap benchmarks, the S&P 600 has an earnings requirement, which is used to ensure the quality of the stocks included and hedge against volatility. To be included, a company must have a market capitalization between $1 billion and $6.7 billion.

It must also:

• Be a U.S. company
• Maintain at least 10% of its shares outstanding
• Have positive earnings for both its most recent quarter and the sum of its trailing four consecutive quarters

The Bottom Line

Small-cap stocks are the stocks of companies whose market capitalization is roughly between $250 million and $2 billion. These companies are attractive investment opportunities for investors as they have the potential for significant growth with the possibility of becoming large-cap stock companies.

However, this potential also comes with higher risk and volatility. Investors have an advantage in potentially beating institutional investors due to the restrictions these institutions face in investing heavily in small-cap stocks. A more balanced, less volatile approach includes small-cap indexes, mutual funds, or ETFs for those who find individual stock research too daunting or risky. It's important to have a solid understanding of the high-risk nature of small-cap stocks and volatile prices, limited information, and lower liquidity. Investors need to conduct thorough research into small-cap companies as they often have less analyst coverage and may present undervalued opportunities.