- Small-cap stocks (“small-caps”) are companies that have a market capitalisation value between $US300 million and $US2 billion.
- Small-cap stocks are usually new companies, those who are focused on a niche market, or those that are struggling financially.
- Small-caps stocks are volatile, risky, and rarely offer dividends, but they have massive growth potential and are often undervalued.
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Small-caps are a source for much of the excitement in the stock market.
Small-caps (short for “small capitalisation”) are companies with a market capitalisation south of $US2 billion. That may sound like a lot, but that figure makes them fledglings in the financial world. They are often young companies with massive room for growth.
But not all small-caps are newcomers. While small-cap companies have the potential to grow into mid-cap or large-cap companies, it works both ways. If a mid-cap or large-cap company sees economic and business challenges that cause them to lose value, they can become small-caps.
Because they’re often expanding fast, you’ll often see the biggest price gains coming from companies in the small-cap category â€” as a group, small-caps tend to perform well, But betting on any individual company is especially risky. Many small-cap companies never quite make it off the ground or fulfil their early promise.
Is that risk worth the reward for you? Here’s what you should know about small-caps.
What are small-cap stocks?
Market capitalisation (“market cap” for short) is the total dollar value of all a company’s stock. A small-cap stock is generally classified as one whose market cap is between $US300 million and $US2 billion.
It’s a diverse group, in several ways. For one thing, companies within it belong to a variety of industries, ranging from the traditional to the high-tech. Many focus on a particular niche within a sector.
Some of the better-known small-caps include:
- Denny’s Corp, the family restaurant chain
- Eventbrite, the event management SaaS company
- Energy Recovery Inc., a company that manufactures fluid flow systems
- Rhythm Pharmaceuticals, a drug manufacturer
- FitBit Inc., makers of wearable fitness devices
Because of their potential for substantial appreciation, small-cap stocks often overlap with growth stocks â€” companies on a fast track, who are outperforming the market overall in terms of return.
But they’re not all bright young things. Some are “fallen angels,” as the financial pros like to say â€” once larger companies whose revenues have waned of late. Some may have shrunk deliberately, to better focus on their core business or a particular market. But some may be struggling or even on the brink of bankruptcy.
Characteristics of small-cap companies
Small-caps are a highly varied group, but they tend to share some similarities.
- They’re â€” you guessed it â€” little guys.These companies are often limited in size or outreach or both. They may be regional or not yet well-established in the field. That means they have lots of room to grow, but also lots of room to fail. They may also become acquisition targets for larger corporations.
- They rarely provide income. Many small-caps don’t pay dividends, preferring to reinvest their profits back into the company for further growth. They’re not a great choice for income investors.
- They’re volatile. Many small-cap stocks attract excitement â€” but not a lot of actual investors (yet). Their trading volume is low. That, along with their general lack of track record, means they tend to see large or sudden swings in price.
What can investors expect from small-cap stocks?
The one predictable thing about small caps is their unpredictability.
“Small-cap stocks can have significant growth potential and often remain undervalued by the market,” says Asher Rogovy, chief investment officer at Magnifina, a portfolio management firm. In fact, small-caps have historically performed quite well over the long-term, even better than large-cap stocks, whose big-growth days are behind them (though they do still appreciate).
In fact, according to Dr. Robert R. Johnson, professor of finance at Creighton University, from 1926 to 2019, small caps have provided investors with an average of 11.6% annual returnsâ€”beating the 10.2% annual returns provided by large-caps.
But as a rule, small-caps are much higher-risk than large-caps. The problem is the volatility â€” the large swings in stock price. Sometimes those swings go in your favour and you can win big. But you could lose big, too.
Over the years, you may well come out ahead, but it could be a stomach-churning ride along the way. And the timing could be tricky if you need to cash in for a specific financial need or emergency.
Small-caps may be getting more scarce
Exciting small-caps may not be easy to find as they used to be. “Today, a fast-growing company will often not go public until it reaches a medium size,” says Alan Vaksman, co-founder of tech-oriented investment company Digital Horizon. “Companies can afford to stay private attracting, for example, venture capital investments.” Or using crowdfunding platforms for financing.
Case in point: Airbnb (ABNB), which went public in December 2020. The home-rental company stayed private until it had massive revenues. And then when it held its IPO, it jumped right to the ranks of the large caps, with a capitalisation of over $US90 billion. So it skipped the small-cap step.
As a result of these trends, “now the small-cap segment is filled with small traditional businesses, like local banks and insurance companies, manufacturers, and so on,” Vaksman adds. “Their potential growth is more limited.”
The financial takeaway
Small-caps have some of the highest rates of growth among stocks, which is what makes them so attractive. But they also are more volatile, with an untried track record â€” or a troubled one. All this poses a greater risk for investors.
Because of the massive diversity in small-cap companies, Tricia Rosen, principal at Access Financial Planning, suggests doing your due diligence.
“Ask yourself why a company is a small-cap before investing in it,” Rosen recommends. “Is it just starting? Is it struggling and shrinking in size? Is it projected to stay small with steady performance? The appropriate investor for each situation may be different even though each is a small-cap.”
If you’re looking for stable investments, you’re probably not in the market for small-caps. But if you’re seriously looking for the Apples and Amazons of tomorrow, some small-cap speculation â€” carefully considered, of course â€” might be for you.
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