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To understand how to invest in small stocks, you need to first know that it’s not just about investing small amounts of money, but owning shares in companies with a smaller market capitalization.
Ever wondered how some investors are able to identify tomorrow’s corporate titans before they become household names around the world? The answer often resides within the fast-moving, lesser-known world of smaller public companies.
These growing companies are called small-cap stocks, and they offer unique opportunities that are not the same as the opportunities offered by the established multinational firms. Investors are drawn to this asset class because of its ability to tap into early-stage growth opportunities.
However, these companies tend to be less established and thus have greater volatility in their share prices. In this article, we’ll explain precisely what small-cap stocks are, how they differ from large-caps, how to find them, and how to get exposure to them prudently.
Quick Answer
Small-cap stocks are investments in smaller publicly traded companies or exposure via diversified funds such as small-cap ETFs. Small-cap investing can provide more growth potential than large-cap investing, but also comes with more volatility, less liquidity and more company-specific risk.
What Are Small-Cap Stocks?
Small-cap stocks are shares of publicly traded companies that generally have a market capitalization in the lower end of financial limits to the mid-tier financial limits.
Market Capitalization (Market Cap) Market capitalization is the total value of a company’s outstanding shares. The terminology used by index providers may be different, but the idea is the same.
These are publicly traded companies that haven’t yet hit the gargantuan valuations of the market-dominating leaders. Note that the term refers to the size of the company itself.
Let’s review the company size spectrum to understand the bigger market picture for these companies:
- Micro-cap: The smallest, most speculative, tradable companies.
- Small cap: New companies with existing operations, but overall lower valuations.
- Mid-cap: Firms of medium size that have moved on from the small-cap stage.
- Large Cap: The biggest and most famous companies in the world.
This asset class is often benchmarked to the Russell 2000, an index that tracks smaller publicly traded companies. Companies in this category are usually earlier in the cycle of growth and hence have a strong growth potential. But this smaller size can also mean less liquidity, meaning the shares may not be as easy to buy and sell.
How Do Small-Cap Stocks Compare to Large-Cap?
Small-cap stocks have greater growth potential but are more volatile and less liquid than larger, more established large-cap stocks.
It is important to know the difference between these two asset classes. Smaller companies are playing the game differently than established giants, according to the Financial Industry Regulatory Authority (FINRA). There is no objective ranking between the two categories. They just play different roles in a portfolio.”
- Growth Potential: Smaller companies tend to have more potential for organic growth. A smaller regional business can double sales much faster than a global conglomerate, in theory.
- Volatility: Small-cap stocks tend to have much more dramatic price swings because the total value of all their shares is smaller. They might be more vulnerable to market conditions.
- Liquidity: Small-cap stocks can be less liquid due to the lower number of shares traded. Big stocks are traded in the millions every day, but there are far fewer active buyers for small stocks.
- Analyst Coverage: Many institutions and analysts do not cover a large number of small-cap companies. This requires a much higher level of research on the part of the investor on his own.
- Business Stability: Large-cap companies have a strong financial status and diversification. Smaller companies are often less stable because they depend on one product line.
| Feature | Small-Cap Stocks | Large-Cap Stocks |
| Growth Potential | Historically higher | Steady, but usually slower |
| Volatility | High | Low to Moderate |
| Liquidity | Generally lower | Very high |
| Analyst Coverage | Limited | Extensive |
| Financial Stability | Developing | Highly established |
How to Invest in Small-Cap Stocks
Investors can buy individual small-cap stocks, buy exchange-traded funds, or select actively managed mutual funds to invest in small-cap stocks.
Once you understand the mechanics, you have to work out the best way to get exposure. Different approaches take different time, expertise and risk appetite. If you are trading through a broker, such as STARTRADER or any other regulated platform, you typically have three main vehicles to choose from.
Individual Small-Cap Stocks
If you want to buy individual small-cap stocks, you have to do your research and buy shares of individual companies through your brokerage account.
When you buy individual stocks, you are assuming the risks of that one particular business. Limited analyst coverage makes it absolutely vital to do your own fundamental research. You need to do the financial statement analysis, get the business model and look at the current debt. And it’s also good to look at the management team and competitive position.
Small-Cap ETFs
Small-cap ETFs offer diversified exposure to hundreds of smaller companies, all in one easy-to-trade investment.
If you don’t want to spend all your time picking individual companies, you can pick an index ETF. These funds gather money from investors to buy a basket of stocks that follow an index, such as the Russell 2000. Diversification lowers the risk of relying on one company by a long shot. The tradeoff is that you will be less exposed to the explosive performance of any one company.
Small-Cap Mutual Funds
Active small-cap funds are managed by professional fund managers who select a portfolio of smaller companies.
Active mutual funds are not identical to passive ETFs. They have a professional management team that researches to pick certain companies that they think will do better. That means you have professional management, but actively managed funds tend to be more expensive in management fees.
How to Find Small-Cap Stocks
Investors looking for small-cap stocks need screening tools to filter companies against market criteria and financial metrics.
There are thousands of public companies out there, so it is next to impossible to find good, smaller businesses manually. To fix that, investors use a stock screener. You enter the parameters, and it spits out a list of companies that fit your needs. Next, you can go deeper into stock research.
Market Capitalization Filters
The first step to making sure your search results show only companies within your desired valuation range is to apply a market cap filter.
You can filter out huge mega-caps and super-speculative micro-caps by setting the max and min thresholds in your screener. This gives you a clean slate of true small-cap companies to investigate.
Sector Selection
Many times, investors will restrict their stock screening searches to a specific industry sector that fits their view of the market.
Maybe you see good prospects for the future in renewable energy or regional health care. You can also filter by sector to find smaller companies in these sectors.
Revenue Growth And Financial Health
If you are looking at small-cap companies, you have to be very strict on revenue growth, profitability, debt levels and cash flow stability.
Financial health is important since smaller companies are more vulnerable to economic shocks. Look for companies with consistent revenue growth. Most importantly you need to check their debt levels, high debt is a big warning sign.
Fundamental Analysis
Fundamental analysis looks at a company’s earnings report, competitive advantages, and overall business strategy.
Mainstream media doesn’t cover small-cap companies, so you have to read their regulatory filings yourself. Make sure to carefully assess the quality of the management team and its competitive advantages.
What Are the Risks of Small-Cap Investing?
The main risks of small-cap investing are lower liquidity, wider bid-ask spreads, higher volatility and a higher chance of total company failure.
But the SEC’s educational guidance is always cautioning about the increased risks, with less analyst coverage, lower liquidity, and scarcer public information than large blue-chip companies. The upside is tempting. Investing in small-cap stocks requires much more homework than buying shares of established blue-chip companies.
- Lower Liquidity: Small-cap stocks tend to have lower trading volumes, making it difficult to buy or sell large positions quickly.
- Higher Volatility: Stocks of small companies can swing wildly on small news.
- Wider Bid-Ask Spreads: Lower trading volume leads to wider spreads and higher transaction costs.
- Limited Analyst Coverage: There is much less information available to the public, creating uncertainty about the real value of a company.
- Compare Failure Risk: Small companies have less financial slack and therefore are much more vulnerable to bankruptcy during recessions.
What Should You Consider Before Investing?
Before you put your money into small-cap stocks, consider your own risk tolerance, your investing time frame and your overall portfolio strategy.
Step back and assess your strategy at the core. Please consider the following checklist before you make any trades:
- Risk Tolerance: Because of the inherent volatility of small-cap stocks, they may not be suitable for investors who have a low tolerance for volatility.
- Time Horizon: The more time investors have to invest, the better they are likely to be able to ride out short-term price swings.
- Portfolio Allocation: A diversified portfolio needs a healthy dose of small-cap exposure. Not sure how much to allocate? First find the number of stocks to own before sizing your small-cap positions.
- Diversification: ETFs offer broad diversification versus the risk of stock picking.
- Liquidity Requirements: Liquidity risk is a problem for investors who need to have their capital at their disposal. If your profile is a good fit for this asset class, a sensible next step would be to test drive a live educational account to sharpen your screening strategies.
FAQs
Small-cap stocks are public companies with a relatively small market capitalization compared to other companies traded on the exchange.
Due to higher price volatility, lower market liquidity and less established business operations, they can afford to take on more risk.
Russell 2000 The Russell 2000 is a popular index that tracks the performance of smaller publicly traded companies in the US.
Yes, small-cap ETFs allow investors to get diversified exposure to a large number of small-cap stocks in one investment, all at once.
Conclusion
The small-cap stock space is a fun place in the financial markets. They give you an ownership stake in smaller companies with potentially higher growth opportunities and significantly higher risk. These companies are still in growth mode, so their share prices are volatile and they tend to be less liquid than corporate behemoths.
There are a number of ways investors can gain exposure to this asset class. You can choose individual small-cap stocks, or you can take advantage of the diversification of small-cap ETFs and actively managed mutual funds.
If you want to be a successful participant, you need to do your homework, diversify intelligently and know what risks you’re taking. Consider small-cap investing as part of your long-term financial goals.
Disclaimer: This content is for educational purposes only and does not constitute investment, financial, or legal advice. CFDs are complex instruments and carry a high risk of rapid money loss due to leverage. Emerging market investments involve additional risks including currency fluctuations, limited liquidity, and regulatory changes. Any references to regulations or market structures are general in nature and subject to change. Seek independent professional advice before making any investment decisions.
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