Definition of small-cap stocks
Small-cap stocks are stocks that have a market capitalization of less than $2 billion. If a company has a market capitalization of $5 billion, it is a large-cap company, whereas if it has a market capitalization of $500 million, it is a small-cap company. Small-cap stocks are often riskier than large-cap stocks, but they can also offer higher potential returns. Small cap companies have a market capitalization of between $50 million and $2 billion. Therefore, these companies are generally too small to be on the radar of institutional investors such as pension funds. That leaves them open to individual investors who are willing to take on more risk in return for potentially higher returns than with larger companies.
Benefits of investing in small-cap stocks
- Access to lesser-known companies - Smaller companies that are often overlooked by larger investors may be great investment opportunities. These companies may have strong fundamentals, but they have lacked the visibility to attract more attention. They can therefore be less risky and have good growth potential.
- Higher potential returns - Smaller companies can often offer higher potential returns than larger stocks because they are riskier. If a company succeeds, it can grow rapidly and gain the visibility to attract larger investors and the company's stock price can rise as a result.
- Diversification - Small caps offer an excellent way to diversify a portfolio. Since they are riskier than larger stocks, they will reduce the overall risk of a portfolio. - The higher expected rate of return - Small caps have higher expected rates of return than large caps. The expected return is the mean or average rate of return that you can expect from an investment.
- Higher Sharpe ratio - The Sharpe ratio is a measure of risk-adjusted return. Small caps have a higher Sharpe ratio than large caps.
- Higher expected return during bear markets - During bear markets, small caps have higher expected rates of return than large caps. - Higher expected return during bull markets - During bull markets, small caps have higher expected rates of return than large caps.
- Higher expected return among low-volatility stocks - Small caps are less volatile than large caps and therefore have higher expected returns.
- Higher expected return among high-volatility stocks - During high-volatility periods, small caps have higher expected rates of return than large caps.
- Higher expected return among low-beta stocks - Small caps are less volatile than large caps and therefore have higher expected rates of return.
- Higher expected return among high-beta stocks - During high volatility periods, small caps have higher expected rates of return than large caps.
Factors to consider when investing in small-cap stocks
- Liquidity - Liquidity refers to how easily you can sell an investment without impacting the price. If a company is thinly traded and you try to sell a large number of shares at once, you may have to sell them at a discount and may not be able to find a buyer.
- Risk - Before you invest in a small cap, you should understand the risk associated with the investment. You can do this by reading the company’s financial statements, researching the industry, and reading the advice of experts. - Expected return - You should also understand how much you can expect to earn from an investment in a small cap.
- Diversification - You should also diversify your holdings by including small caps in your portfolio. Diversifying your holdings will reduce your risk by distributing your money across different types of investments.
- Liquidity - Before you invest in a small cap, you should also make sure that you can easily sell the investment in a reasonable amount of time if you need to.
- Sector - You should also consider the sector that the company is in.
- Size - You should also consider the size of the company. Companies with smaller market caps are often referred to as small caps.
- Growth potential - You should also consider the growth potential of the company.
Types of small-cap stocks
There are many different types of small-cap stocks, but there are a few that stand out from the rest. These include:
- Cyclical stocks - Cyclical stocks are companies in industries like mining, construction, or financial services. When the economy is growing, these sectors do well, but when the economy slows down, they tend to do poorly.
- Defensive stocks - Defensive stocks are companies in low-growth industries that are less risky. Some examples include healthcare, utilities, and food producers. - Specialty stocks
- Specialty stocks are companies in industries that depend on one or a few products. If those products do well, the company does well, but if they don’t, the company does poorly.
- Emerging markets stocks - Emerging markets stocks are stocks of companies based in Asia, South America, and Africa. These companies have higher expected rates of return than companies based in the United States and Europe because they are riskier.
Small-cap stock research
- Fundamentals - You should always research a company’s fundamentals before you invest in it. You can read a company’s financial statements to get a better understanding of its debt, revenue, and profitability and to find out where they earn its money. You can also read analyst reports to gain a better understanding of how analysts view the company.
- Investment Theories - You can also research investment theories that may help you better understand why certain stocks are a better investment than others. These investment theories include:
- Sector Analysis - You can also research the sector that the company is in to see how it is performing compared to other sectors. You can look at the S&P 500 or MSCI indices to see how the entire market is performing.
- Macroeconomics - You can also research how the macroeconomics of the country where the company is based and how that will impact the company’s revenues, expenses, and profits.
- Liquidity - You should also make sure that you can easily sell an investment if you need to.
