What is Small-Cap Investing and How Does it Work?
It might seem obvious, but when it comes to investing, different investors have different levels of risk tolerance. As such, your neighbor may have one investment strategy when it comes to the stock market that you’d never consider in a million years, even with the growth rates they boast about when investing gets brought up in conversation. While Wall Street and the stock market inherently have some level of volatility, it’s up to you to determine how much of that volatility you can stomach as an investor.
If you’re not too risk-averse and like the sound of outperforming the S&P 500 by investing in an asset class with major growth potential, market cap (short for market capitalization) investing may be a good strategy to implement.
Of all your options, small-cap stocks, as opposed to mid-cap or large-cap stocks, offer some of the best revenue growth around—assuming you can accept the increased risk. Read on to learn more about what small-cap investing is, how it works, and how to get started implementing this strategy in your own portfolio.
What is small-cap investing?
When it comes to any kind of market cap investing, you first need to understand a concept called market capitalization. Market capitalization refers to the total value of any outstanding shares of a specific company’s stock. The phrase is also used in conjunction with cryptocurrencies like Bitcoin (BTC).
You can quickly calculate this number by multiplying the price of one share any a company by the total number of shares available, or outstanding. For example, a company may have 8 million outstanding shares with an individual stock price of $50. That means that their market capitalization is $400 million. This is a valuation method that puts a lot of stock (no pun intended) in the stock market, since it specifically cares about how the secondary market views a company.
It’s important to remember that market capitalization is more a reflection of how individual and institutional investors view and value a company than that company’s specific performance. Share prices can often be overvalued or undervalued, flying in the face of any given company’s past performance (see last month’s GameStop fiasco for a recent example of this).
Small-cap companies vs mid-cap or large-cap companies
In market capitalization investing, companies are divided into different categories depending on the value of any given company’s total market cap. A small-cap company is valued between $250 or $300 million dollars and $2 billion dollars, a mid-cap company is valued between $2 billion dollars and $10 billion dollars, and a large-cap company is valued at over $10 billion dollars.
It’s also worth noting that there’s one smaller subset of companies classified as micro-cap. Micro-cap companies are businesses with values generally ranging from $50 million dollars to about $300 million.
When it comes to following the performance of different small-cap companies, you’ll want to look at the NASDAQ, since it predominantly features small-cap stocks. Large-cap stocks are generally found on the Dow Jones Industrial Average.
Getting started as a small-cap investor
One reason some individual investors look into small-cap investing is that they can usually be invested in as an individual without having to worry about larger mutual funds getting involved. Keep in mind that a mutual fund can sometimes invest in a large number of shares in a business, and since small-cap companies have less stock on the market, they can’t support that kind of cash flow from mutual funds.
Here are a few things to keep in mind as you’re evaluating different small-cap investment opportunities for your portfolio:
Think carefully about a company’s industry and potential market size
An important consideration to make whenever you’re evaluating a small-cap company is what sort of industry they serve. Many times, it can be beneficial to find a small-cap company that is on the verge of cutting-edge technology or a facilitator of a major industry transition.
It’s also important to think about companies that are likely to grow by impressive amounts. While this might seem hard to quantify, if you think about markets that have the potential to be major contenders or serve a broad amount of the population, any business that fits that bill could offer you a major payout once their stock spikes.
Especially when combined with value investing strategies, small-cap companies can offer an incredibly high return, consistently outperforming the S&P 500. This is why it’s just as important to find stocks that are likely to grow as well as stocks that are likely to hold value.
Understand potential obstacles in liquidity
One thing to keep in mind when you’re getting started in small-cap investing is that different small-cap stocks may be easier or harder to trade than others. This can ultimately impact the liquidity of your portfolio since large-cap stocks generally trade at a higher value and more often than small-cap stocks.
That being said, there are some situations when you can mitigate this risk. Generally speaking, most people only want to buy small-cap stocks when they think they’re undervalued or have reached a valuation that seems appropriate. As such, one of the best ways to minimize your risk when investing in small-cap stocks and maximize your liquidity is to plan to hold your small-cap investments for the long-term.
Costs/Fees
Like any other form of investing, there are going to be some fees or costs associated with your trading. While your brokerage may charge certain fees in connection with your trading activities, you’re most likely going to face costs when you sell your small-cap stocks and file taxes each year. Capital gains taxes are owed anytime you sell an asset that has appreciated in value, and with the growth possible in small-cap stocks, that amount could be larger than other investments you may have sold before.
As much of the analyst coverage will make you aware, small-cap investing is also riskier than investing in large-cap or even mid-cap companies. As such, it’s important to remember that in some investment strategies, losses are a cost you may not anticipate Be sure to only invest money that you can afford to invest in order to mitigate any losses’ impact on your overall personal finances.
Pros/Cons
Pros
Can offer impressive growth
As has been mentioned multiple times throughout this post, small-cap stocks are a high-risk, high-reward form of investment. If a company really takes off, having stock in them can offer a major payout to individual investors who were savvy enough to buy before the rest of the industry caught on. Keep in mind that some of the largest tech companies by market-cap today started out as small-cap investments, and it’s clear to see just how lucrative small-cap investing can potentially be.
Small cap index funds do well compared to other indexes
Small-cap index funds generally perform quite well when compared to other indexes like the S&P 500. For example, from the late 90s through 2014, small-cap indexes like the Russell 2000 index outperformed the S&P by over 110%. This makes them an attractive way to work towards diversification in your portfolio alongside other securities like ETFs or real estate, although it’s important to remember that at this time large-cap stocks are currently performing better.
Cons
One of the riskier investment strategies
Although you can win big by investing in small-cap securities, it’s important to remember that smaller companies don’t always have the stable business models associated with mid-cap and large-cap businesses. As such, their futures are no sure thing, which can manifest with major losses just as often as major gains. If you aren’t able to absorb these kinds of risks, it’s a good idea to stay away from small-cap investing.
Requires work if you aren’t investing in small-cap index funds
One other drawback of investing in small-cap businesses is that their financial information isn’t as readily-available as larger companies. As such, determining whether financial records point towards consistent positive performance or not can be more difficult, which adds another layer of work to the valuation process.
The bottom line
While small-cap investing certainly isn’t for everyone, that doesn’t mean that you shouldn’t look into considering utilizing some of the strategies in your own portfolio. For example, while small-cap investing in individual stocks is certainly the riskiest form of small-cap investing, it can offer a major upside. By that same token, one way to potentially generate passive income using small-cap investing is by looking at small-cap indexes that help to spread some of your risk across multiple businesses.
It’s important to remember that even if a particular investment strategy doesn’t match your risk tolerance, it’s not a bad idea to understand the concepts behind it. Market capitalization is a concept that comes up frequently in stock market analysis, so even if you personally don’t dabble in small-cap investing many of the concepts relating to market caps are still worth understanding as part of your own financial literacy.
Ultimately, how you choose to invest your money is up to you. The most important thing is to get started investing as soon as possible if you really want your money to grow over time. Whether you choose small-cap investing or a different strategy, using the stock market to increase your wealth is a time-tested way to grow your savings.
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