What Is Considered a Small-Cap Stock?
Small-cap stocks are generally those with a market capitalization of $300 million to $2 billion. The market cap is the total number of outstanding shares times the share price. The dollar ranges associated with market cap classifications change periodically, usually upwards.
Pros & Cons of Investing In Small-Cap Stocks
- Small-cap stocks often outperform large-caps, on average, as they have more room for growth.
- Small-cap stocks often do well at the beginning of an economic recovery as investors become optimistic about the future of the economy and are willing to take on more risk.
- Small-cap stocks tend to have more volatile share prices.
- Many small-cap companies are not as well-established are larger companies, which poses potential risks in economic downturns. Small companies are more likely to fail during a recession.
Large-Cap & Mid-Cap vs. Small-Cap Stocks
Large-cap stocks have a market cap of at least $10 billion, while mid-caps are stocks with market caps of $2 billion to $10 billion. The Small-caps segment has market caps of $300 million to $2 billion.
Generally, the smaller the company, the less established or financially capable it is, and the higher the risk it is to invest. However, smaller companies usually have a greater potential for growth, and investors generally weigh risk versus reward in electing what investments to add to their portfolios.
Small-Cap Stocks vs. Penny Stocks
Some investors think small-cap stocks sell for low prices, but that isn't necessarily the case. Small-cap has to do with what the market thinks the company is worth based on how many shares are outstanding and how much those shares are trading for. Penny stocks are generally those trading for less than $5 a share, although some other companies may see their share prices drop temporarily. Penny stocks may be traded on a major stock exchange orover the counter (OTC).
Investing In Small-Cap Stocks
Factors investors may wish to consider before selecting small-cap stocks to their portfolio are:
- The company's revenue growth
- It's earnings growth
- Balance sheet flexibility
Many smaller companies are unprofitable and burn cash, meaning that funding issues could arise in the future. Small-cap companies with a large cash balance, and improving cash from operations (CFO) figures may be less vulnerable than those without those traits.
Other metrics or factors to look at include:
- The price-to-earnings ratio: market cap divided by earnings-per-share (EPS).
- Past stock price movements
- The company's total addressable market.
Companies with a large addressable market and whose stocks are on the rise are often more attractive. Many small-cap investors look for signs of a healthy, growing company.
Tip: Investors who invest in small-cap stocks have usually decided that the potential for significant growth is worth the greater risk of investing in small-caps.
How To Invest In Small-Cap Stocks
Investors can trade small-cap stocks just like do for any equity security by doing so through a brokerage account with a company like Robinhood, E*Trade or eToro. In addition to buying individual stocks directly, investors can also gain exposure to small-caps by investing in an exchange-traded fund (ETF) that tracks the Russell 2000 Index, or contains a different portfolio allocation to small-cap stocks. Many mutual funds also focus on small-cap stocks.
Should You Invest in Small-Cap Stocks?
When deciding whether or not small-cap stocks are right for your portfolio, it's a good idea to think about what the rest of your portfolio consists of. Diversification is important, and it might make sense to diversify stock holdings by investing in a mix of large-cap, mid-cap and small-cap companies.
Investors may also want to think about how much risk and volatility they can tolerate. Risk-averse investors or those who can't handle the stress of volatility may want to consider avoiding small-caps. On the other hand, if you can handle some volatility in exchange for the possibility of higher returns, it's worth investigating small-caps.
Important: The information contained here is purely for educational purposes and does not represent investment recommendations.