What Are Small-Cap Stocks, and Are They a Good Investment? (2024)

What Is a Small-Cap Stock?

A small-cap stock is a stock from a public company whose total market value, or market capitalization, is about $250 million to $2 billion. The precise figures vary.

Small-cap stock investors are generally looking for up-and-coming young companies that are growing fast. That is, they're looking for the large-cap stocks of the future.

Key Takeaways

  • A small-cap stock is generally that of a company with a marketcapitalizationof between $300 million and $2 billion.
  • Small-cap stock investors seek to beat institutional investors by focusing on growth opportunities.
  • Small-cap stocks historically have outperformed large-cap stocks but are also more volatile and riskier.

Understanding Small-Cap Stocks

The "cap" in small-cap stands for capitalization. The term in its entirety is market capitalization.

This is the market's current estimate of the total dollar value of a company'soutstanding shares. To calculate a company's market capitalization, multiply its current share price by the number of outstanding shares.

Classifications such as "large-cap" or "small-cap" are approximations that change over time. Furthermore, the precise definition of small-cap stocks vs. large-cap stocks may vary among brokers.

One misconception about small-cap stocks is that they arestartupsor brand new companies. In reality, many small-cap stocks are of companies that are well-established businesses with strong track records and great financials. And because they are smaller, small-cap stock share prices have a greater chance of growth.

Small-Cap Stock vs. Large-Cap Stock

As a rule, small-cap stock companies offer investors more room for growth but also bring greater risk and volatility than large-cap stock companies.

A large-cap offering has a market capitalization of $10 billion or higher. For large-cap stock companies such as General Electric (GE) and Coca-Cola Co. (KO), aggressive growth may be in the rear-view mirror. Such companies offer investors stability and dividends but rarely fast growth.

Historically, small-cap stocks have outperformed large-cap stocks. That said, whether smaller or larger companies perform better varies over time based on the broader economic climate.

For example, large-cap stock companies dominated during the tech bubble of the 1990s, as investors gravitated toward stocks such as Microsoft (MSFT), Cisco (CSCO), and AOL Time Warner. After the bubble burst in March 2000, small-cap stock companies became the better performers, as many of the large caps hemorrhaged value in the crash.

One advantage ofinvestingin small-cap stocks is the opportunity to beatinstitutional investors. Many mutual funds have internal rules that restrict them from buying small-cap stock companies. In addition, the Investment Company Act of 1940 prohibits mutual funds from owning more than 10% of a company's voting stock. This makes it difficult for mutual funds to build a meaningful position in small-cap stocks.

A stock smaller than a small-cap is known as a micro-cap. That is a publicly-traded company with a marketcapitalization of about $50 million to $300 million.

Small-Cap Stock vs. Mid-Cap Stock

Investors who want the best of both worlds might consider mid-cap stocks, which have market capitalizations between $2 billion and $10 billion. Historically, these companies can offer more stability than small-cap stock companies yet confer more growth potential than large-cap stock companies.

However, for self-directed investors, spending the time to sift through small caps to find a diamond in the rough can prove to be time well spent. Even in our data-rich world, great small-cap investments fly under investors' radars because they get little coverage from analysts.

Small-Cap Stock vs. Penny Stock

Shares in both small-cap stocks and penny stocks have lower market value than large- or mid-cap stocks. Penny stocks have small market capitalizations, so they could be considered small-cap stocks. However, there are specific characteristics that make a stock a penny stock, which not all small-cap stocks share.

Penny stocks have share prices lower than $5. Some are traded on the New York Stock Exchange. Most, though, are traded directly (known as over the counter or through "pink sheets") rather than through a stock exchange. Penny stocks are considered high-risk investments due to their:

  • Low price
  • Lack of liquidity
  • Wide bid-ask spread

Unlike a penny stock, small-cap stocks can have a share price greater than $5. They are categorized based on their market capitalization.

Advantages and Disadvantages of Small-Cap Stocks

Small-Cap Stocks Pros and Cons

Pros

  • Potential for growth

  • Lower share price

  • Variety of businesses

  • Less popular

Cons

  • Volatile prices

  • High risk

  • Less available information

  • Low liquidity

Advantages of Small-Cap Stocks

  • Potential for growth: Because these companies are smaller, they have more potential for growth relative to large-cap companies. This means investors in them have the potential to make a large profit.
  • Lower share price: The share price of small-cap stocks is often lower, making your initial investment easier. And share prices can't be artificially pushed up by mutual funds or hedge funds, since there are regulations to prevent financial institutions from investing heavily in them.
  • Variety of businesses: Small-cap companies aren't only start-ups. They can be found in all industries, and many of them have been in business for a while. This provides a variety of options for investing.
  • Less popular: Because there is less popular information about small-cap companies, they aren't as well-known as large- and mid-cap companies. This means they are often priced below their value and can provide a solid return on investment.

Disadvantages of Small-Cap Stocks

  • Volatile prices: Smaller companies react more to volatility in the market because they have less financial cushion than their larger counterparts. As a result, small-cap stocks can see sudden and wide price fluctuations.
  • High risk: While small-cap companies have a lot of growth potential, they have equal potential to fail. Small-cap stocks are a riskier investment than large-cap stocks. The companies usually have less access to investment capital and are more sensitive to market changes. This makes them a riskier investment.
  • Less available information: Financial institutions and analysts don't give small-cap companies as much coverage as large- and mid-cap ones. As a result, you need a solid understanding of company valuation and time to do your own research before investing.
  • Low liquidity: The smaller size and lower popularity of small-cap companies make their stock less liquid. When a company isn't as well-known, it can be harder to find a seller when you want to buy shares. It can also be harder to sell shares when you want to exit the market.

How to Invest in Small-Cap Stocks

If you have the time and the knowledge necessary to research individual small-cap stocks, you can invest in individual companies. Their stock can be purchased through a brokerage account. Before investing in a company, you'll want to investigate its:

  • Earnings and revenue growth: Even if a company isn't yet making a profit, you want to see that it is growing and increasing its revenue.
  • Price-to-earnings ratio: The P/E ratio compares the current share price to the earnings per share to measure the value of the company's shares.
  • Price-to-sales ratio: If the company doesn't yet have any earnings per share, you can use the P/S ratio to measure how it performs compared to other small-cap stocks.

If researching individual small-cap stocks is too time-consuming or seems too risky, you can also buy small-cap mutual funds or exchange-traded funds (ETFs). These might track broad small-cap indexes, specific industries within the small-cap market, or investment goals like value or growth.

Small-Cap Stock Indexes

Many brokerages offer small-cap stock index funds, either as mutual funds or as ETFs, to track the U.S. small-cap market. Depending on the brokerage you use, you could, for example, invest in the Vanguard Small-Cap Index Fund (VSMX) or the Fidelity Small Cap Index Fund (FSSNX).

However, there are two main small-cap indexes that are used as benchmarks for the small-cap equities market.

The Russell 2000

The Russell 2000 is a small-cap stock market index composed of the 2000 smallest companies in the Russell 3000. The index is frequently used as a benchmark for measuring the performance of small-cap stock mutual funds. It is managed by London'sFTSE Russell Group.

Because it tracks such a broad share of the small-cap market, the Russell 2000 is used by many mutual funds and ETFs. It is heavily weighted by financials, industrials, and healthcare.

S&P 600

The was established by Standard & Poor's (the creator of the S&P 500). It uses a capitalization-weighted index to broadly track the performance of small-cap stocks on the U.S. equities market. It includes 600 companies and represents close to 3% of the U.S. market.

Unlike many other small-cap benchmarks, the S&P 600 has an earnings requirement, which is used to ensure the quality of the stocks included and hedge against volatility. To be included, a company must have a market capitalization between $750 million and $4.6 billion. It must also:

  • Be a U.S. company
  • Maintain at least 10% of its shares outstanding
  • Have positive earnings for both its most recent quarter and the sum of its trailing four consecutive quarters

Are Small-Cap Stocks a Good Investment?

Small-cap stocks can be a good investment. They typically have the potential for growth, much larger than large-cap stocks/blue chip companies, so if an investor gets in at a good price, they may see a good return. Small-cap stocks are more risky and volatile than the stocks of larger, more established companies, so investors must take extra care in their analysis before making any investment decisions.

Which Is Better, Small-Cap or Mid-Cap?

Whether small-cap stocks or mid-cap stocks are better depends on the specific company. Any company with good fundamentals, a strong business strategy, smart leadership, and a competitive edge, can be a good investment, whether they are a small- or mid-sized company. Small-cap stocks have more growth potential than mid-cap stocks, so investors may see a better return; however, small-cap stocks are also more risky and volatile than mid-cap stocks, so the loss potential is greater.

Is Small-Cap Good for the Long Term?

Yes, small-cap stocks can be good for the long term. If you can invest in a small-cap stock that has good fundamentals and overall healthy analysis, the stock will most likely grow over the long term. If you can invest before a bull run on the market and hold the stock for the long term, then you could see a strong financial return.

The Bottom Line

Small-cap stocks are the stocks of companies whose market capitalization is roughly between $300 million and $2 billion. These companies are attractive investment opportunities for investors as they have the potential for significant growth with the possibility of becoming large-cap stock companies.

Because there is more upside than a large-cap stock, investors do take on more risk; but on the bright side, small-cap stocks have historically performed better than large-cap stocks. Investors should carefully evaluate companies with a smaller market cap to determine if there is growth potential before making any investment decision in the hopes of a future windfall.

What Are Small-Cap Stocks, and Are They a Good Investment? (2024)

FAQs

What Are Small-Cap Stocks, and Are They a Good Investment? ›

Limited liquidity: Small-caps may have fewer outstanding shares, making them harder to purchase or sell. Lower or no dividends: Especially compared to larger companies, small-caps may have low dividend payouts or none at all, choosing instead to use their cash for operations.

Are small-cap stocks a good investment? ›

High risk: While small-cap companies have a lot of growth potential, they have equal potential to fail. Small-cap stocks are a riskier investment than large-cap stocks. The companies usually have less access to investment capital and are more sensitive to market changes.

What does small-cap stock mean? ›

Small-cap stocks are shares of companies with total market capitalization in the range of about $300 million to $2 billion. Small-cap companies have the potential for high rates of growth, making them appealing investments, though their stocks may experience more volatility and pose higher risks to investors.

Why do people invest in small-cap? ›

Small cap funds often focus on companies that are undervalued by the market. These undervalued opportunities present a chance for investors to buy into promising companies before they are widely recognised and their stock prices increase.

What is a small-cap stock investment strategy? ›

Strategies for successful small-cap investing

Rather than putting all your eggs in one basket, consider spreading your investments across companies of different sizes, regions and sectors. This approach helps mitigate the risks associated with individual companies or industries.

How risky are small-cap stocks? ›

Small-cap stocks tend to offer greater returns over the long-term, but they come with greater risk compared to large-cap companies. The greatest downside to small-cap stocks is the volatility, which is greater than large-caps.

Why avoid small-cap stocks? ›

-Small-cap is known for its volatility or sharp price fluctuations leading to greater uncertainty and risk for investors. Moreover, they also have liquidity concerns, limited resources and stability, and higher rates of failure.

What are the best small stocks to buy now? ›

Best small cap stocks for long term
S.No.NameCMP Rs.
1.Manaksia Coated62.00
2.R Systems Intl.437.10
3.Prime Fresh194.80
4.Apollo Finvest827.90
23 more rows

How long should I invest in small-cap stocks? ›

Hence, it is important to have a long-term investment window while investing in Small-Cap Funds so that you give sufficient time to your investment to generate returns. The recommended time frame is eight to ten years.

Are small caps good for 2024? ›

Given the changing macroeconomic backdrop, we outline why we see potential value for investors in small caps in 2024. The consensus is that interest rates look to have peaked, with markets now pricing in cuts across many major economies in 2024, something which could prove beneficial to small caps.

What is the disadvantage of small-cap fund? ›

Small-cap mutual funds perform well over a long period of time. However, over a short period of time, they tend to be very volatile. So if you plan on withdrawing/redeeming your money from the mutual fund early, you could suffer losses. Sure, you could also make gains, but there is always the risk.

What are examples of small-cap stocks? ›

Small Cap Value Stocks
SymbolCompany NamePrice To Sales
DOLEDOLE PLC0.1
SBHSALLY BEAUTY HOLDINGS INC0.3
UVVUNIVERSAL CORP0.4
EIGEMPLOYERS HOLDINGS INC1.2
26 more rows

How to choose small-cap stocks? ›

Factors to Consider While Analysing Small-Cap Stocks
  1. Company's management – Irrespective of the size of the company, you must look into the top management, i.e., the CEO, CFO, etc. ...
  2. Company growth – One way to look at a company's growth is to check how much a company is earning and how much money they have in hand.
May 15, 2024

Is it worth investing in small-cap stocks? ›

Key Benefits of Small-Cap Investing:

Diversification - lower correlation to large-caps improves overall portfolio efficiency. Growth potential - younger, faster growing companies earlier in life cycle. Sector/Industry breadth - wider array of sectors and industries compared to large-caps.

Does Warren Buffett invest in small-cap stocks? ›

As Buffett inferred, even the world's greatest investors are attracted to small-cap stocks. He might not buy small caps today. But he did back in 1972 when he bought See's Candies for just $25 million (equivalent to over $637.5 million today).

How to make money from a small-cap? ›

Have a 10-year horizon. On a trailing return basis, small-cap funds have delivered great returns over the last one, three and five years. But the shorter your holding period in a small-cap fund, the higher is your chance of making losses from it or earning measly returns.

Is it safe to invest in small-cap for long-term? ›

Long-Term Investors: Small-cap investments can be volatile in the short run, making them suitable for investors with a time horizon of seven years or more. Over the long duration, small-cap funds have the potential to generate significant returns.

Is it better to invest in small-cap or large-cap? ›

Large-cap funds are less risky than small and mid-cap funds. Small and mid-cap funds have higher growth potential than large-cap funds. Large-cap funds are good for conservative investors. Mid and small-cap funds are suitable for medium-risk takers to aggressive investors.

Will small-cap stocks do well in 2024? ›

Investors now expect fewer cuts starting later in 2024, and that “higher for longer” rate outlook hit small caps much harder than large caps, explains Kristy Akullian, head of iShares investment strategy, Americas, at BlackRock.

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