If you’re interested in investing in a category of fast-growing, up-and-coming companies, you may want to look into small-cap stocks.
But along with their high growth potential, small-caps also come with more risk than investing in larger, more established companies. Therefore, investors must understand the various factors that underpin the performance of small-cap stocks.
What are small-cap stocks?
Small-cap refers to a certain range of market capitalization (or “market cap”), which measures the total value of a company’s outstanding shares. It’s calculated by multiplying the number of outstanding shares by the current stock price.. For example, a company with a stock price of $50 with five million shares outstanding has a market cap of $250 million. The number of outstanding shares is the most important factor in determining a company’s size, according to the Financial Industry Regulatory Authority (FINRA).
There are several levels of market cap. The segments may vary by different organizations, but FINRA describes them as:
| Classification | Market cap range |
|---|---|
Mega-cap | $200 billion or more |
Large-cap | $10 billion to $200 billion |
Mid-cap | $2 billion to $10 billion |
Small-cap | $250 million to $2 billion |
Micro-cap | $250 million or less |
Fund analysis firm Morningstar, however, defines small-caps not by market value but by whether these companies are in the bottom 10% of the capitalization of the US equity market.
An important caveat from FINRA: Because stock price is determined by the market, market cap represents a company’s perceived value and not necessarily a reflection of its actual value.
Potential benefits of small-cap stocks
Small-caps attract investor interest because of the potential their future holds.
“I look at small-caps as an opportunity because they tend to be fast-growing companies. And high-growth companies tend to propel your portfolio,” said Zaneilia Harris, a certified financial planner (CFP), president of Harris & Harris Wealth Management Group and a former Nasdaq analyst.
She added, “There’s also the potential that larger companies may buy small-caps, especially if they have the adequate teams in place to support them in expanding.”
Behaviorally, small-cap stocks “tend to outperform at the beginning of a bull market or economic expansion,” according to Morningstar, when investor appetite for riskier stocks is heightened and stocks of all sizes are in demand.
Other advantages of small-caps, suggested by the American Association of Individual Investors (AAII), include:
- Less competition: Small-caps are generally overlooked by large institutional investors who cannot take a large enough position in a small company. For example, if a large investor wants to take a 10% stake in a small-cap stock with a valuation of, say, $500 million, making that $50 million investment is often not worth their while.
- Higher growth potential: Small companies can take more chances and respond to “events and trends more efficiently than larger companies.”
Small-caps may also be more affordable lately. A recent Morningstar analysis noted that, although US small-caps have underperformed the broad equity market over the past 20 years, they appear “cheaper now relative to the broad market than at any time in the last 20 years.”
Risks associated with small-cap stocks
Small-caps can be especially vulnerable to macroeconomic factors, such as high interest rates, unfavorable market cycles and changing economic relationships.
Small companies are more sensitive to higher interest rates than larger companies, according to Morningstar, because they often must borrow more frequently in order to grow. As a result, they may be forced to pay the prevailing, higher rate, or even risk bankruptcy. Furthermore, a Morningstar analyst, looking to 2024, suggested that small-caps may struggle until the uncertain economic environment becomes more “normalized.”
Some financial advisors see a possible new economic normal that may be unfavorable to small-caps.
“Since the 2010s, we’ve had some changes in how the economy works. All the top companies are tech companies now, and small-caps are underperforming because they can’t compete with these mega winner-take-all companies,” said Marcio Silveira, a CFP, former equity analyst and owner of Silvergreen Sustainable Investments.
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“You can find great opportunities in individual small-cap stocks, but you need to do a lot of fundamental analysis to find the hidden gems,” he said.
Other small-cap risks noted by AAII include:
- Higher volatility: Their smaller size means small-caps generally experience more volatility brought on by market fluctuations.
- Lower transparency and data: Fewer analysts cover small companies compared to larger ones, so data on small-caps may be limited for individual investors.
- 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.
Diversifying your portfolio with small-cap stocks
Diversifying your portfolio among and within different asset classes (stocks, bonds, etc.) reduces the chances, as well as the impact, of loss on your investments. Within the asset class of stocks, for example, you can diversify by holding equities representing different economic sectors (e.g., consumer, health care, technology), market caps, national origins, as well as dimensions such as growth versus value.
While small-caps have underperformed over the past decade, some analysts see new potential for these stocks to pull their weight inside a diversified portfolio.
| Index | Three-year (annualized) | Five-year (annualized) | 10-year (annualized) |
|---|---|---|---|
S&P 500 (large-cap stocks) | 8.1% | 13.2% | 12.4% |
S&P 500 SmallCap 600 (small-cap stocks) | -0.3% | 7.1% | 8.5% |
S&P Global data as of April 30, 2024
In terms of valuations, “the segment of the US market where [we] see the most opportunity, the most upside from a forward-looking valuation perspective is that smaller-cap segment,” according to a Morningstar analyst.
How to invest in small-cap stocks
Once you’ve set up and funded a brokerage account, there are three basic ways to invest in the small-cap sector.
Invest in index funds
Perhaps the simplest way to invest in small-cap stocks is to buy a low-cost index fund. You can buy a pooled financial product, such as an exchange-traded fund (ETF) or mutual fund, that tracks an index that covers a universe of small-cap stocks. The best-known ones are the Russell 2000 Index, the Standard & Poor’s SmallCap 600 Index and the MSCI USA Small Cap Index.
Invest in active funds
Another option is to choose an ETF or mutual fund with an active manager who will determine the best small-cap stocks to include in the fund.
“By using funds like this, you are hiring experts to conduct due diligence. They will be evaluating how the company is run, their internal controls, what skill sets make up the management team, their products and services, and their internal efficiency and effectiveness,” said Harris.
To research an actively managed small-cap fund, AAII suggests that investors:
- Review the portfolio manager’s small-cap strategy and approach
- See how the fund performed in good and bad markets, compared against similar funds, across a 10-year period
- Check out the fees, such as annual fund operating expenses and shareholder fees, and avoid funds that charge sales commissions or have annual sales fees.
- Check out the expense ratio, especially as actively managed funds tend to have higher expense ratios than index funds.
Invest in individual stocks
Lastly, you can put together your own portfolio of individual, small-cap stocks. There are myriad ways of approaching this. For example, given the relatively low valuations of small-caps, as noted above, an investor may want to employ so-called small-cap value (i.e., relatively underpriced) stocks within a diversified portfolio.
Nasdaq suggests using the following valuation metrics when screening for small-cap value stocks (Low values infer that the company may be undervalued):
- Price-to-earnings ratio (earnings per share): For stocks with low P/E ratios, as company profits improve, stock prices should follow.
- Price-to-sales ratio (sales per share): This ratio is used to compare a company’s sales to its share price, with a lower ratio indicating that a stock may be undervalued relative to its peers.
- Price-to-book ratio (book value per share): This ratio looks at the value of a company’s assets on its balance sheet. Here again, a lower ratio may indicate that a stock is undervalued.
- Price-to-cash flow (cash flow per share): Some investors prefer this ratio, which measures a stock’s price against its cash flow, as it is more difficult to manipulate than earnings.
- Enterprise value-to-EBITDA ratio: This ratio looks at a firm’s enterprise value compared to its earnings before interest, taxes, depreciation and amortization (EBITDA), calculating how the company would appear to an acquiring company looking to purchase the entire business in a private transaction.
Frequently asked questions (FAQs)
There are different metrics you can use to screen for stocks of interest, depending on what characteristics are important to you. For example, for those interested in identifying small-cap value stocks should consider metrics such as earnings, sales, book value and cash flow per share, etc.
Another way to identify promising stocks is to use a mutual fund with an active manager, who will research and evaluate small companies on behalf of the fund investors. There are a number of ways to evaluate such a fund, including learning about the manager’s strategy, reviewing the fund’s performance over time and determining its fees and expenses.
You can look at different small-cap indexes — and different time frames — to get a sense of the performance of a certain universe of small-caps. For example, the Morningstar US Small Cap Index shows a year-to-date total return of -1.3%, a three-year annualized total return of -1%, a five-year annualized return of 6.7% and a 10-year annualized return of 7.5% through the end of April 2024. Going back even further, the index has posted a 12% annualized return over the past 15 years. Other small-cap indexes, such as the Russell 2000 Index and the S&P SmallCap 600 Index, show similar return figures.
Yes, they generally are more volatile, in part because they are more sensitive to higher interest rates than larger companies. As noted above, small companies frequently have to borrow money in order to fuel their growth and, therefore, are forced to pay the prevailing higher rates.
Yes. Small-caps are typically affected more by economic contractions, recessions and other macroeconomic factors. This is because they have more variability in their underlying businesses with fewer resources than larger companies, according to Nasdaq.
