What Are Small-Cap Stocks?

Whether you’re a beginner or seasoned investor, you may be looking for “the next big thing.” If you spend hours scouring the various brokerage sites, you may be intimidated by how many choices there are.

Having a well-balanced portfolio with large-, mid- and small-cap stocks can be an effective way to increase your investment potential, but how can you find what will fit your individual investing needs? If you’re interested in learning how to find a “diamond in the rough,” investing in small-cap and micro-cap stocks could be the ticket to finally finding one.

What Are Small-Cap Stocks?

Small-capitalization stocks, also known as small-cap stocks, are typically companies with a market cap of less than $2 billion.

A common misconception people may have about small-cap stocks is that they are “penny stocks.” Penny stocks are not normally listed on the national stock exchanges (New York Stock Exchange, Nasdaq and American Stock Exchange) and must be purchased over the counter, trading with prices below $5 per share. Exchange-listed stocks must continue to meet listing requirements that ensure companies stay up-to-date with their audited financial statements and trade with adequate liquidity to facilitate smoother buying and selling of shares.

On the other hand, small-cap stocks are determined by their overall market cap, not just the price of their available shares. A company’s market cap is calculated by multiplying the number of outstanding shares by the stock’s current price. This valuation shows how the public (investors and analysts) feels about a company’s growth, risk and potential. This size classification can change over time and is ultimately used to classify the range of sizes into three major groups: large-cap, mid-cap or small-cap companies.

Another misconception about small-cap stocks is that they are brand new, start-up companies that have just entered the market. In the small-cap universe, you can find companies in all stages of their life cycle, from early growth to mature and declining. Thankfully, new tools, like the ones from AAII, can help investors capitalize on small-cap stocks that are often in the shadows of other larger companies. Formulating a well-thought-out small-cap strategy can be beneficial if you do your research.

Examples of Small-Cap Stocks

Some examples of small-cap stocks include Fossil Group Inc. (FOSL), La-Z-Boy Inc. (LZB), Pitney Bowes Inc. (PBI), Tupperware Brands Corp. (TUP) and NetGear Inc. (NTGR) These small-cap companies have a market cap of less than $2 billion, which categorizes them as small-cap organizations.

Many investors also establish a minimum market-cap level, such as $300 million, to help ensure that enough investors are trading in the companies to facilitate the purchase and sale of their positions. There are thousands of small-cap stocks to choose from, in all kinds of industries.

Determining what defines a good small-cap stock can be challenging at first, but understanding how they react to different economic scenarios can help you choose which ones are the best for your portfolio.

Pros and Cons of Investing in Small-Cap Stocks

If you follow investment channels or podcasts, you have heard investors talk about the “small-cap advantage.” However, before you buy your first share of a small-cap stock, it’s important to understand the various advantages and disadvantages there can be. The benefits of adopting a small-cap strategy include:

• Less competition: Small-cap companies are often overlooked by large institutional investors, such as hedge funds, banks and trusts, because of their size. Thankfully, this gives the individual investor more opportunities to find “diamonds in the rough.”
• More affordable: Small-cap stocks have been out of favor recently, giving them attractive valuations relative to large-cap companies.
• Growth potential: Many small market-cap companies have significant room for future growth compared to mid- or large-cap organizations. They can take more chances as well as take advantage of events and trends more efficiently than larger companies.
• Improper pricing leverage: The market is a very efficient pricing system. However, small-cap stocks are more prone to being mispriced because there are fewer investors following news about smaller companies, which can leave room for investors to take advantage of underpriced shares.
• Better returns: Small-cap stocks have outperformed large-cap stocks over the long term. They may not outperform every year, but have streaks that have led to their long-term return advantage.

As you can see, there are countless benefits of developing a small-cap strategy. Being more affordable, offering more growth potential and having less competition make small-cap stocks an attractive opportunity for first-time, as well as seasoned, investors. Depending on several factors such as your risk tolerance, flexibility and time, identifying good small-cap stocks could be a lucrative addition to diversify your portfolio.

However, in contrast, a few disadvantages of investing in small-cap stocks include:

• Higher volatility: These smaller market-cap stocks tend to be influenced more strongly by fluctuations in the market.
• Less transparent: Small-cap stocks have significantly less coverage and data than large-cap stocks.
• Time-consuming: Investors will need to do extensive research to find out how viable a small-cap stock is, due to less coverage and data.
• Limited liquidity: These stocks can be difficult to purchase or sell at a favorable price due to how many available, outstanding shares they have.
• Lower dividends: Unfortunately, because of the greater concentration of emerging companies, many small-cap stocks do not pay dividends or offer lower dividend payouts compared to their mid- and large-cap counterparts.
• Increased bankruptcy risk: Small-cap companies have a higher risk of going bankrupt because they don’t have access to the same amounts of lending as large-cap companies do.

It’s important to weigh the pros and cons before choosing whether to invest in small-, mid- or large-cap stocks. Every investor has different goals and tolerance, therefore, it’s crucial to evaluate your individual lifestyle and asset preference before proceeding. AAII encourages investors to do extensive research and due diligence before choosing an investment strategy that’s right for them.

How Can I Invest in Small-Cap Stocks?

If you’re interested in taking the plunge into developing a small-cap strategy, there are numerous approaches. There are a few ways you can go about investing in small-cap stocks such as:

• Purchase individual small-cap stocks
• Invest in an actively managed small-cap mutual fund
• Rely on passive funds based upon small-cap indexes such as the Russell 2000

How you invest in small-cap stocks will depend on your experience trading shares of smaller companies, your risk tolerance during market fluctuations, and the amount of time you are willing to spend researching these companies in depth. Therefore, it’s important to choose a small-cap strategy that fits your financial ability. Thankfully, there are a few options out there if you want to start investing in small-cap stocks.

Purchase Individual Small-Cap Stocks

If you decide to purchase individual small-cap stocks on your own, it’s important to do your own research and allocate funds that you can be flexible with, since small-cap stocks tend to be more volatile and fluctuate frequently with market changes. You can use AAII’s stock screens to help weed out nonviable small-cap stocks and pick ones that have a good growth history, strong financial backing and stable prices.

Invest in a Small-Cap Fund

If you are interested in investing in a mutual fund, it is recommended to do extensive research on the small-cap strategy and approach used by the portfolio manager. The range of size of the companies that mutual funds can invest in will vary greatly, even if the fund has the small-cap label in its name. Look at the weighted average market cap of the portfolio holdings to ensure that the fund is truly a small-cap fund.

Small-cap stocks can react to market conditions differently than large-cap stocks. Never invest in mutual funds blindly; review how the small-cap funds performed in good and bad markets. Most importantly, compare the fund performance against other funds with the same investment style. A well-managed fund performs consistently relative to its peers over time, so it’s best to look at a 10-year period to see if the small-cap mutual fund would be an attractive investment relative to the risk that the fund takes on.

Compare the fees charged by the small-cap funds you are considering. There are two main mutual fund fee structures: Annual fund operating expenses and shareholder fees and loads. Operating fees include the total cost of paying managers, accountants, legal fees, marketing, etc., and shareholder fees include any sales commissions and other one-time costs when you trade back and forth.

Actively managed funds tend to have higher expense ratios than index funds, so make sure that the manager is adding enough value to make up for the added expense. Small-cap funds often carry higher expense ratios.

If you are doing your own research, it is best to avoid small-cap funds that charge any loads or sales commissions. Also, be wary of funds that have annual sales fees paid out of 12b-1 charges. The 12b-1 fee is an operational expense and, as such, should be included in a fund’s expense ratio.

Evaluating the associated fees may change your mind and point you to rely on a small-cap index or purchase individual shares on your own.

Rely on a Prominent Small-Cap Index

There are a number of small-cap indexes, and many mutual funds and exchange-traded funds (ETFs) that track these indexes. One of the most prominent small-cap indexes is the Russell 2000 index. It is constructed by excluding the largest 1,000 stocks of the largest 3,000 stocks traded on the domestic exchanges. The Russell 2000 is actually a smaller subsection of the Russell 3000, which is a cap-weighted index. Other noteworthy small-cap indexes include the S&P Small-Cap 600 index and the MSCI Small-Cap index.

What Are “Shadow Stocks” and Micro-Caps?

Shadow stocks is a term coined by James B. “Jim” Cloonan, the late founder of the American Association of Individual Investors (AAII). This term refers to investing within the “micro-cap” sector—companies that have a market cap below $300 million. After analyzing credible sources, Cloonan realized that, at the time, many professional investors were ignoring this type of investment strategy because it was too difficult for large institutions to develop into investment products that they could scale into multi-billion-dollar portfolios. Cloonan was frustrated with this disregard and deemed it a potentially lucrative strategy to focus part of a portfolio on micro-caps.

Cloonan’s objective was to construct an easily managed portfolio that takes advantage of the many studies that revealed that, on average, the smaller the market cap of a company’s stock, the higher the expected return over the long run; and also the deeper the value of a company’s stock price, the greater the expected long-term return. With these factors in mind, he started the AAII Model Shadow Stock Portfolio, which has shown great results and effectively grown over the years. As an AAII member, you can get exclusive access to our Shadow Stock model portfolio and other small-cap investment tools.

Perceived negatives such as illiquidity (not being able to trade stocks as easily) can actually benefit micro-cap investors in the long term. While micro-cap investing can seem attractive to some, it is highly risky and time-consuming. It’s important to fully understand that micro-cap investing is not for everyone—especially if you are a beginner. Micro-cap stocks are best suited for investors who are more risk-tolerant and can handle the increased volatility in exchange for higher potential gains.

Are Small-Cap Stocks a Good Investment?

If you’re wondering whether small-cap stocks are a good investment, it’s important to consider your own goals and risk tolerance. Because small caps are often more volatile, offer little to no dividends, but have the potential for higher returns, they can benefit certain investors, but not all. Basically, it’s “play at your own risk.” It can be exciting to find great shadow stocks that fall under the radar, as long as you understand the associated risks. Good small-cap stocks are sometimes hard to find, but with the right amount of research and patience, you’re bound to find a “diamond in the rough.”

AAII recommends doing extensive research, following stock grades and screeners, as well as evaluating your investment goals before choosing to invest in small-, mid- or large-cap stocks. By doing your own research, you can determine if adopting a small-cap strategy could be a good addition to diversify your portfolio.

Evaluating Small-Cap Stocks With A+ Investor

We know choosing what to invest in can feel overwhelming, especially if you’re thinking about including a small-cap strategy in your portfolio. With so many small-cap stocks and funds to choose from, it can be difficult to know which investment strategy will fit your individual needs. Building a well-balanced portfolio with a variety of large-, mid- and small-cap stocks can help optimize your investment potential. AAII’s financial education subscriptions are focused on how a small-cap strategy, as well as a diversified portfolio, can help you reach your investment goals. Thankfully, AAII’s A+ Investor subscription allows members to take advantage of financial tools such as:

• Custom stock screeners
• Stock screen power rankings
• Top and bottom performing funds
• Fund/ETF screener and compare tools
• Stock grade screens

These are just a few of the numerous tools you can gain access to as an A+ Investor subscriber. Sign up today to take control of your investment goals and financial education journey.