Investing > Small-Cap Stocks Explained

Small-Cap Stocks Explained

There are tons of small-cap stocks out there, but investing in the right one could make you a fortune.

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Reviewed by
Updated May 20, 2021

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Are you tired of hearing endless talk about huge companies that run the economy?

You’ve seen headlines of these massive corporations that move the entire market up a few points when they have a good shareholder meeting. As an investor who is looking to make the most of their money, you are probably sick of hearing about the same-old businesses, and you are ready for something new. 

That’s where small-cap stocks come in. ✅

If you had invested in small-cap stocks over the past twenty years you would have walked away with two times more profits than an investor that exclusively bought large-cap companies. But how do you know which one of these assets is worth buying, and which ones are duds?

In this article, we will explain everything you need to know about investing in small-cap stocks. From finding the perfect stocks to fill out your portfolio to sniffing out the bad companies that you should steer clear of. 

Small-cap companies can be rocky waters and they are not for every investor. Being aware of the key indicators of a bad stock will keep you safe, and more importantly, keep you profitable. Let’s see how small-caps work, how to pick the right ones, and what purpose they can serve in a balanced growth portfolio.

What you’ll learn
  • What Are Small-Cap Stocks?
  • Why Invest in Small-Cap Stocks?
  • Finding the Right Small-Cap Stocks
  • When to Avoid Small-Cap Stocks
  • Small-Cap Portfolio Allocation
  • The Impact of a Recession
  • How to Invest in Small-Cap Stocks
  • Alternatives to Small-Caps
  • Conclusion
  • Small-Cap Stocks: FAQs

What Are Small-Cap Stocks? 📖

If you want to understand what a small-cap stock is, you have to start by understanding how the stock market operates. Basically, every publicly traded stock on the market can have its value defined by the cost of all its shares. Market capitalization is a way for investors to break down how much it would cost to buy every share of a company.

Market cap changes as the share value changes, and investors label companies differently depending on their value. While there are companies all along the spectrum, from micro-cap to mega-cap, it’s important to remember that even the largest companies have failed—large-caps are not always a foolproof investment.

Micro-CapSmall-CapMid-CapLarge-CapMega-Cap
Companies worth under $300 million.Companies worth between $300 million and $2 billion.Companies worth between $2 billion and $10 billion.Companies worth between $10 billion and $200 billion.Companies worth more than $200 billion.

Small-cap stocks are on the lower side of the valuation spectrum but they are still slightly higher than micro-cap stocks. For context, micro-cap stocks are dirt cheap companies that may have some serious business problems or are not bringing in a lot of profit. 

Micro-cap securities are known to be risky because fraud is common. Mid-Cap companies, on the other hand, are more established businesses that are either growing and expanding their business. While some of these companies show good signs of movement, others are regressing and downsizing.

Small-cap stocks rest between the two. Many small-cap stocks are in the early stage of their lifecycle and are establishing themselves in the market, but some of these stocks used to be larger companies but have retracted due to various reasons.

Because many small-cap stocks are new businesses, they provide a great opportunity for investors who are looking for market inefficiency. When a company is new, it is hard to tell what its true value is—investing in a small-cap stock that you suspect is undervalued can lead to massive growth.

Not all small-cap stocks are going to have the same history, and it will take some investigation to understand what exactly you are buying. The point is, small-cap stocks are of lower value, higher risk, and, potentially, higher reward than larger companies.

Why Invest in Small-Cap Stocks? 🔎

The point of investing is to see your money grow, so while you may be investing in a small-cap company now, you will want to see it move along the spectrum and eventually become the most valuable company of all time 🤞 (or at least do reasonably well). 

There are different reasons to invest in companies all along the spectrum. Generally, while large-cap company stocks offer stability and long-term growth, small-cap stocks present more risk, but they also have the chance to undergo explosive growth.

Some key differences between large-caps stocks and small-cap stocks.
As asset classes, small and large caps have fundamental differences.

Another good thing about small-cap stocks is they won’t have their price driven up by large institutions which are trying to pad their bottom line. Institutional investing is a concern for many investors, some are even worried about their interference in crypto.

Oftentimes, large institutional investment services see small-cap stocks as liabilities because they are not entirely safe. Many of these services have rules in place that limit the amount of stock their buyers can purchase. This is good news for individual investors.

Another good reason to invest in small-cap stocks is that the companies might not be valued correctly. While value stocks can come from any industry of the stock market and any market capitalization, you may have more luck nailing down a value stock in the small-cap range because they are more likely to be overlooked by those institutions and the investing public alike.

Pros

  • Small-cap stocks have the potential to return many times your initial investment
  • You can avoid large institutions that drive up the price of assets
  • You may find or luck into a value stock and have a high return

Cons

  • Small-cap companies are riskier than large ones
  • Small-cap stocks may stagnate or go out of business
  • Small-cap stocks aren’t going to have the trading volume of the largest companies, this makes it more difficult to buy and sell shares

How to Find Good Small-Cap Stocks 🕵️‍♀️

It takes a lot for a company to succeed in the marketplace. When companies are starting out, your risk as an investor is high because so many companies fail. But if you rely on the fundamentals you can find a solid company. Knowing when to stick out the downturns and when to cut your losses and run can be key to long-term growth.

To find a great small-cap stock you need to be looking at a variety of factors. A good way to understand what small-cap stock has large-cap potential is by looking at some of the biggest companies in the world as counterintuitive as that may sound.

The world’s largest companies were at one point or other small-cap stocks. If we analyze the decisions they made early on in their lifecycle, we can understand why they erupted. Some of the largest companies right now are tech companies that relied on disruptive technology and innovative services and products to drive their growth.

Disruptive Companies 🚀

If a company is providing a new and innovative service that fundamentally transforms the space they are selling in, they will be able to take control of a large share of the market. This is something that happened with Apple, Microsoft, and even Tesla.

However, these companies are hard to come by. Many technologies that investors think are going to take off simply don’t because of other fundamental problems with the business. 

This can come from a product being too ambitious and the business not having the infrastructure and assets to deliver. There can also be talent issues where a company doesn’t have the right staff to create the product they have promised.

When speculating on companies that are presenting new technology or services, you should stay informed about that business and do your research. Try to understand what they are offering and if it is practical, and stay away from businesses and products that you don’t understand.

Good Management 👨‍👩‍👦‍👦

One of the keys to the success of a company is that they are under excellent management. While this is true for massive companies, it is especially the case for small businesses. 

A company may be able to withstand bad leadership when it is a multi-billion dollar corporation (unless they’re running a massive Ponzi scheme), but this is because there is a point where decisions become so dissociated from a central person that it is unlikely for one person to take the whole company down.

Contrast this with a small company, one person at the top can make or break the business. Bad decisions will be executed quickly and can lead to large losses. When analyzing small-cap stocks, pick a management team that is running a company for the long term.

Built to Last 🏗

You can definitely make money from companies that pop up overnight, explode in value, and diminish into obscurity. These shooting stars show up all the time, but these kinds of gains often come with disproportionate risk where the stock’s beta is out of control.

Some small-cap companies will have this kind of growth. Be cautious of whether the growth is isolated, potentially a sign of a pump and dump scam, or if it is sustainable growth. You have the potential to lose your investment when a stock is burning out.

That’s why you should instead try to look for companies that are equipped to weather the storm. Investors who are interested in value stocks will often talk about how it’s important to have a robust company with irreplicable products. This can come from things like important patents, proprietary technology, or unique assets.

All of this is important because it means the company is profitable and has the potential for meaningful and sustained growth. These companies will withstand the marketplace when the competition starts to ramp up and other businesses attempt to replicate products.

When to Avoid Small-Cap Stocks ⚠️

There are plenty of situations where it may be best to steer clear of small-cap stocks altogether. Long-time investors will have horror stories of value traps—stocks that look promising but never end up going anywhere because of a fundamental flaw with the business.

A good reason to avoid a small-cap stock may be because of a company rapidly decreasing in value because of bad news. This is something that we saw with Hertz (HTZGQ) last year after they declared bankruptcy—the stock price tumbled even after they revised their decision.

Hertz Global Holdings
HTZGQ plummeting from $95 per share to $1 over a 5-year period. Image by TradingView.

Despite the stock price plummeting and the company closing many locations, there were investors dogpiling on the stock with the hopes of it recovering. The stock was instead delisted. While there may be signs of life for the company now, investors were making a very risky call buy purchasing when they did.

Another bad stock was Luckin’ Coffee. To the dismay of investors, the coffee chain had been inflating its profits by as much as $310 million. When news broke it led to many executives losing their jobs, the stock price plummeting, and ultimately the company being delisted from the stock market.

When companies lie to you, it’s hard to tell whether you are investing in a good product. There might not be any way to know what you are actually investing in and there may not be people to warn you about your purchase. This is one of the possible risks of investing in small-cap companies.

How Much of My Portfolio Should Be in Small-Cap Stocks? 📊

Small-Cap stocks are likely to be the riskiest assets you hold, and even if you are an aggressive investor, small-caps will likely make up a small portion for your portfolio. The average portfolio may have anywhere from 50% to 75% of its investments dedicated to stocks with the remainder being set aside for bonds or other “safe haven” assets. Of the stock portion, investors have to decide how much they are willing to bet on small companies.

The most aggressive models may have 40 to 60% of their portfolio dedicated to small and mid-cap stocks. With the minority of that breakdown lying in small-cap stocks.

It is not a good idea to put too much of your portfolio totally in small-cap stocks, but if you are not too risk-averse, you may decide to dedicate more of your portfolio to these risky assets. This can help increase your portfolio’s growth.

How Do Recessions Affect Small-Cap Stocks? 💡

The largest issue with small-cap stocks is their inability to withstand downturns in business. If your company doesn’t have the large cash reserves and the infrastructure to withstand hardships, then they are not likely to overcome challenges that span months and years.

Russell 2000 small-cap stock index
SPY (blue) compared to the Russell 2000 small-cap stock index (orange) since mid 2019. Image by TradingView.

When it came to the COVID pandemic, the S&P 500 was hit less hard than small-cap stocks. In general, the S&P 500 was able to recover more steadily than small-cap stocks. Smaller companies were able to leverage their position in the recovering market in late 2020 and into 2021. The recovering economy may continue to significantly help small companies.

RUT TVC
Russell 200 (orange) compared to NDX (green) since mid 2019. Image by TradingView.

Large-cap companies had a much easier time recovering from the pandemic compared to small-cap stocks. These large companies bounced back quickly and sustained growth from early on in the downturn.

How to Invest in Small-Cap Stocks 👇

Investing in the stock market doesn’t have to be difficult. Investing in small-cap stocks is as easy as finding the right stock brokerage and funding your account. While you can go through small companies and try to analyze them individually, it is also easy to buy an index that contains many companies and diversifies your account.

A few popular brokers trusted by traders around the globe are the following:

Fees
Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0

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General
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Powerful tools for professionals

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Best for

Active options and penny stock trading

Active traders

Promotion
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Minimum initial deposit

$0

$0

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$0

$0

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Huge discounts for high-volume trading

Pioneer of commission-free stock trading

Best for

Active traders

DIY stock trading

Promotion

Free stock

Rating
Fees

Minimum initial deposit

TS Select: $2,000

TS GO: $0

$0

$0

Commissions

$0

Vary

$0

Account minimum

$0

$0

$0

General

Highlight

Powerful tools for professionals

Huge discounts for high-volume trading

Pioneer of commission-free stock trading

Best for

Active options and penny stock trading

Active traders

DIY stock trading

Promotion

Free stock

If you don’t want to think about what company or what index to buy, you can try one of the top robo-advisors. These services are able to select assets for you to buy automatically and can take away the paralyzing fear of picking the wrong stock. The robots can even help you continue to fund your account automatically.

Small-Cap Funds ✅

Small-cap funds can be an easy way to diversify your portfolio and invest in small-cap stocks. The Russell 2000 index is one of the most popular small-cap stock indexes. This index keeps track of the smallest 2,000 companies on the Russell 3000 index and accounts for many of the publicly traded small-cap stocks on the market.

Some exchange-traded funds (ETFs) such as IWM and VTWO both track the small-cap index—both ETFs have seen returns of over 15% for the first half of 2021. At the same time, the ETF VOO which tracks the S&P 500 has only seen returns of around 12%.

While small-cap stocks have had a strong recovery over the past few months, the returns of an S&P 500 tracking portfolio and a small-cap tracking portfolio have been nearly identical for the past 5 years. The only difference has been the slightly greater volatility of the small-cap index.

Small-Cap Funds
VTWO (orange) vs VOO (blue) in the 2016 – 2021 period. Image by TradingView.

Alternatives to Small-Caps 📚

Different stocks can help balance your portfolio and keep your risk levels in check. It isn’t necessary to throw all of your weight into small-cap stocks if you don’t want to expose yourself to too much risk. As we’ve seen, over between 2016 and 2021, the returns for small-cap index funds and S&P 500 tracking index funds have been comparable.

If you decided to invest in the S&P 500 exclusively, you would expose yourself to less risk. This is because an ETF that tracks the entire index will contain large companies that help insulate the stocks from bankruptcies and excessive losses.

Besides small-cap stocks, there are also micro-cap stocks. These are even smaller companies than small-cap stocks and offer much greater risk in return for greater reward. Many of these micro-cap stocks aren’t even sold on the regular market and have to be bought over the counter.

Small-Cap vs. Penny Stocks ⚖️

Penny stocks are generally shares that are trading for under $5—this means that the stocks are accessible and it is easy for investors to buy many shares. Trading penny stocks can be a lot riskier than small-cap stocks, and there are often problems with liquidity depending on how well known and traded the companies are. 

However, some small-cap stocks are traded at penny stock prices. When investing in penny stocks investors should be wary of artificially inflated prices and scams that arise from low volume.

Small-Cap Stocks vs. Bigger Stocks ⚖️

Large stocks are in the later stages of growth. They are less likely to experience massive amounts of growth because they have already undergone their most profitable stages. 

Investors will have decided how they feel about a company and they will have set the price. Normally, you will be paying a premium to invest in bigger companies as the market brings the price more closely in line with a fair value.

There are always opportunities to find inefficiencies, especially when the market is excessively turbulent. Small-cap stocks will be more prone to inefficiencies but they can also have harsher reactions to problematic events—this can even lead to companies being delisted from the stock market.

How Small-Cap Companies Impact the Economy 🌎

Small-cap companies are the driving force behind job growth in the country. They provide an important service by introducing new products and services into the market, and they also give investors a way to build wealth. 

Small-cap companies are able to act more quickly than large companies. This gives them the flexibility and adaptability they need to meet consumer needs before other businesses can.

The overall impact of small-caps on the market is considered good because smaller businesses don’t only create jobs—they offer innovation (or try to do so) and can potentially move the economy into new uncharted territory. Also, as small-caps are run by non-gazillionaires, they compete for the capital that would otherwise go to large corporations—which is a welcome change of pace in an economy where the super-rich are getting super-richer faster than everyone else.

Conclusion 🏁

Small-cap stocks are risky, but their risk can be worth the rewards. Just make sure you don’t bite off more than you can chew, and watch out for recessions that disproportionately affect the little guys.

Now that you understand everything about investing in small-cap stocks, you can take over the stock market. You are truly a force to be reckoned with! But be careful—figuring out the performance possibilities of this lucrative asset class will pay dividends, but avoiding bad investments is key.

Small-Cap Stocks: FAQs

  • Are Small-Cap Stocks Riskier?

    Small-cap stocks are riskier than large-cap stocks because they have fewer resources to withstand problems in the market. Small-cap stocks are more likely to be inaccurately valued by the market, which will make investments more volatile.

  • What Should I Look For in Small-Cap Stocks?

    You should look for small-cap stocks that have good management, the ability to outperform competitors, and no fundamental flaws in their company. Some small-caps may look like perfect companies except for one fatal flaw, and that can be all it takes to hold it back from success.

  • What is a Small-Cap Index?

    A small-cap index is a fund that tracks small-cap stocks on the market and closely matches their performance. Investors use these indexes to invest in a variety of stocks without having to individually purchase each company.

  • What Percentage of the US Stock Market Is Held in Small-Cap Stocks?

    Small-cap stocks account for about a quarter of the companies on the US Stock Market. According to a report by Credit Suisse, there are about 6,000 companies traded on the NYSE and NASDAQ. Of those companies, about 1,600 are small-cap stocks.

All reviews, research, news and assessments of any kind on The Tokenist are compiled using a strict editorial review process by our editorial team. Neither our writers nor our editors receive direct compensation of any kind to publish information on tokenist.com. Our company, Tokenist Media LLC, is community supported and may receive a small commission when you purchase products or services through links on our website. Click here for a full list of our partners and an in-depth explanation on how we get paid.

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