Deciding to buy your first small small-cap stock is one of the most exciting decisions that you can make. This is because, while small-cap stocks might come with slightly more risk, they can also set your portfolio up to potentially experience higher-than-average long-term returns.
That being said, if you’re new to small-cap stocks and investing then it can be difficult to know where to get started. To help out, we’re here to offer a comprehensive guide to small-cap stocks, investing in them, and how they can be a valuable addition to your portfolio.
If you’re already well-versed in small-cap stocks then feel free to jump ahead and check out some of our small-cap investment ideas.
What Does Market Capitalization Mean?
Have you ever heard phrases like “Apple just became the first $2 trillion company ever” or “Airbnb is now valued at $100 billion” and wondered what exactly this means?
Statements like these are referring to the market capitalization of that company. If you’re not familiar, market capitalization is an easy way for investors to assign a total value to a company’s equity. Market capitalization is calculated by multiplying a company’s total outstanding shares of stock by the current market price of those shares.
For example, if a company goes public and issues 50 million shares of stock at $1 each, they would have a market capitalization of $50 million (50,000,000 x $1 = $50,000,000). If those shares of stock grew in value to $2 over the course of the next year then the company would have a market capitalization of $100 million (50,000,000 x $2 = $100,000,000). On the flip side, if the price of their shares sank to just $0.5 then they would have a market capitalization of just $25 million (50,000,000 x $0.5 = 25,000,000).
Due to this, it’s possible for some companies to be worth much more than others, even if their stock price is lower. For example, shares of Apple stock cost about $140 while shares of the fast-casual Mexican restaurant Chipotle cost over $1,800. Even though Apple has a much lower share price, they have significantly more shares outstanding than Chipotle does. This is why Apple’s market cap is over $2 trillion compared to just $52 billion for Chipotle.
When it comes to classifying the different levels of market capitalization, stocks are generally broken up into three categories:
- Large-cap stock – Companies that have a market capitalization of $10 billion or more are considered large-cap stocks. For these, you can think of massive conglomerates like Home Depot, Amazon, Google. These companies are incredibly diversified and generate billions of dollars in revenue each year. For example, for FY 2020, Home Depot brought in $110 billion in revenue, $11.4 billion in net income, and had $2 billion in cash on hand.
- Mid-cap stock – Companies that have a market capitalization between $2 and $10 billion are considered mid-cap stocks. For these, you can think of companies that are still well-known but aren’t quite giants such as American Eagle Outfitters, Avis Budget Group, or Stitch Fix. To compare, for FY 2020, American Eagle brought in $4 billion in revenue, $191 million in net income, and had $360 million in cash on hand.
- Small-cap stock – Companies that have a market capitalization of less than $2 billion are considered small-cap stocks. For these, you can think of companies whose businesses are not quite established yet and do not have the size and scale of other companies. A few examples would be Groupon, Playboy, or Appharvest. For FY 2020, the online coupon company Groupon brought in revenue of $1.4 billion, lost 287 million, and had $850 million in cash on hand.
In most cases, the biggest difference between small, mid, and large-cap stocks is the size and scale of their business. Based on the numbers above, you can see that a large-cap stock like Home Depot made almost three times as much profit as a mid-cap company such as American Eagle earned in total revenue.
On that same note, it’s very likely that just one of Amazon’s business divisions (such as their cloud computing division) earns more money than Groupon’s entire business does.
So, when it comes to investing, which type of stocks should you invest in? Well, to be honest, this answer is going to be a little different for everyone. That’s because the answer depends on your goals as an investor as well as factors like your risk tolerance and time horizon. To visualize this, imagine that you were starting a new workout plan.
It wouldn’t make sense to just jump into a random workout routine with no strategy. First, you’d probably spend some time thinking about what you’re trying to achieve by working out. Then, you’d tailor your workouts to help you reach your goals. For example, if you’re trying to bulk up and gain muscle mass then you’d want to incorporate lots of heavy lifting. Or, if you want to lose weight then you should keep the weight low and do lots of cardio. Since everyone has slightly different fitness goals, there is no “right workout plan”. Investing works the same way.
Everyone’s investing strategy will be different depending on how much risk they’re willing to take, the returns that they’re satisfied earning, as well as how long they plan to keep your money invested.
With that said, we believe that small-cap stocks offer some of the most exciting opportunities for investors because they have the best potential for outsized long-term gains.
Let’s take a closer look at investing in small-cap stocks and some of the ways that small-cap stocks can be a valuable addition to your portfolio.
What Are Small-Cap Stocks?
A small-cap stock is any company that has a market capitalization of between $300 million and $2 billion. Anything less than $300 million is considered a micro-cap stock and anything bigger than $2 billion is considered a mid-cap stock. While some small-cap stocks are companies that have just recently gone public, it’s also common for small-cap stocks to be companies that are well established, have good financials, and have been in business for years.
In general, small-cap stocks are also usually companies that don’t receive the same level of media and analyst attention when compared to larger companies.
For example, consider how much attention analysts give to a company like Tesla. Tesla is discussed and analyzed every single day, regardless of whether there is any new information. Tens of thousands of investors listen to their earnings reports and investors will spend hours afterward pouring over every single detail. People will even go so far as to follow their CEO on Twitter to try and interpret information from his tweets. Due to this, Tesla’s stock price reacts incredibly quickly when any new information is reported.
On the other hand, small-cap stocks don’t receive nearly this level of scrutiny. Since they are smaller companies and sometimes operate in less flashy industries, institutional investors won’t spend a lot of resources analyzing them. This generally provides other investors with a great opportunity to identify overlooked information. If you can identify a small-cap stock that has unrealized potential then it gives you a good chance to outperform institutional investors. Uncovering information that other investors have not yet realized is referred to as having asymmetric information.
Continue reading to learn more about small-cap stocks and investing.
So, does all of this mean that small-cap stocks are always a good investment? Let’s take a look.
Are Small-Cap Stocks a Good Investment?
When you go through the process of buying a car, your final decision is usually based on a few factors. If you plan to use the car to haul lots of cargo then you’ll probably buy a pickup truck or large SUV. On the other hand, if saving money at the gas station is your main priority then you’ll probably want to go with something more fuel-efficient like a Toyota Prius or Corolla. Choosing the right car is going to depend on what you plan to use the car for.
Stock investing is fairly similar. There is no “one size fits all” investment that can be deemed better than all others because it all depends on what your financial goals are. Some investments are great if you don’t mind taking risks and are only interested in maximizing your gains. On the other hand, if your main focus is not losing your initial capital then you’ll want to use a very different strategy.
With that said, small-cap stocks are a great tool for diversifying your portfolio. Since their shares usually trade at cheaper prices, it is easier to buy a large stake in a small-cap company for a relatively small investment. Additionally, the single-stock risk that’s present when buying small-cap stocks is usually worth it for the opportunity of larger potential returns.
Here are a few of the benefits of investing in small-cap stocks:
- Greater potential for larger returns – Small-cap stocks are usually in a better position for long-term growth when compared to larger stocks. This is because it’s generally easier for a business to grow a $5 million revenue by 20% annually than it is to grow a $5 billion revenue.
- Potential for information inefficiencies – As we mentioned earlier, small-cap stocks generally receive less analyst attention. This means that there’s greater potential to discover stocks that are mispriced.
- Institutional investors generally stay away – Institutional investors have hundreds of millions of dollars that they need to deploy. While some institutional investors invest in small-cap stocks, most small-cap stocks just don’t have the market cap to support investments of this size. The Securities and Exchange Commission also regulates the size of the position that institutional investors are allowed to take in a company. This means that retail investors have a good opportunity to get in on small-cap stocks before institutional investors.
However, since no investment is perfect, let’s discuss a few of the drawbacks to investing in small-cap stocks:
- Higher risk – Investing in small-cap stocks brings a greater opportunity for higher returns, however, it also brings more risk. Smaller companies inherently have a higher risk of failing when compared to a company like Amazon or Apple. Additionally, smaller companies have less access to sources of financing which can make it difficult for them to bridge gaps in cash flows or expand into new markets.
- Low liquidity – Since there are fewer shares of small-cap stocks available, it can be difficult to buy/sell at your desired price.
- Time-consuming – The fact that small-cap stocks receive little analyst coverage is a good thing if you’re on the hunt for undiscovered growth opportunities. However, this also means that you bulk of the research will fall on your shoulders.
- Price volatility – Since their businesses are not as well established, smaller companies’ success or failure can usually rest on just a handful of factors. Due to this, the prices of small-cap stocks tend to be more volatile than large-cap stocks.
Continue reading to get a better idea of whether small-cap stocks are a good investment for you.
Small-Cap Stocks vs Large-Cap Stocks
Let’s take a quick break from small-cap stocks to focus on their counterparty: large-cap stocks. Mainly, how do small-cap stocks compare to large-cap stocks?
Large-cap stocks are companies with a market capitalization of $10 billion or more. When you think of a large-cap stock you can think of companies like Disney, Boeing, or The Home Depot. For the most part, the heavy growth phase of these companies is behind them and, by this point, these company’s stocks are well-established. They will likely continue to grow each year but it would be incredibly rare for a stock like Disney or Boeing to double or triple in a single year (once-in-a-lifetime pandemic years aside).
Large-cap stocks provide lots of the opposite benefits when compared to small-cap stocks. For example, while their potential for growth isn’t as high, large-cap stocks offer investors stability and less risk. This is because large companies are usually very diversified and make money in a handful of different ways. Consider a company like Disney, which makes money from their theme parks, resorts, broadcast TV networks, cruise lines, etc. Even if one of these business lines were to fail completely, Disney would still have plenty of ways to keep making money. This translates into less risk for investors.
Large-cap stocks are also known for often paying consistent dividends. This can be attractive for investors because it offers them income that is more or less guaranteed in addition to any growth that the stock experiences. On the other hand, small-cap companies generally choose to invest all of their profits back into growing their business instead of offering dividends.
Continue reading to learn more about the differences between small-cap stocks and large-cap stocks.
If investing in small-cap stocks is something that appeals to you then you’re probably wondering how you actually go about picking the right small-cap stocks. Let’s take a closer look at that.
How to Pick Small-Cap Stocks
There are plenty of different strategies when it comes to picking the right small-cap stocks. Usually, picking the right stocks will usually require developing a bigger overall strategy that fits your goals as an investor. Once you have established an investment strategy, you can determine how small-cap stocks fit into that strategy. More often than not, your strategy will involve investing in a range of different stock and asset types.
The most important factor when picking small-cap stocks to invest in is to make sure that you understand the investment that you are making. Before committing to an investment, you should make sure that you fully understand the potential benefits as well as (more importantly) the potential risks.
Finally, if choosing individual stocks is not something that appeals to you then you have two options. First, you could invest in index funds, which track the prices of hundreds of different stocks. This is a good way to match the return of the overall market and minimize your risk. Second, you could work with a financial advisor or investment professional who can help you with research and decision-making.
Continue reading to learn how you can pick some of the best small-cap stocks to fit your portfolio and goals as an investor.
How to Invest in Small-Cap Stocks
Once you have discovered small-cap stocks that are a good fit for your portfolio, investing in them is fairly straightforward. Really all that is required is to open up a brokerage account and fund it with some initial capital. Most brokerage accounts are very simple to open and can be opened easily after verifying your identity.
After you’ve opened a brokerage account, you will be able to go through and select the stocks that you want to buy. From there, investing will become an ongoing practice for you as you track the returns of your portfolio and make adjustments along the way.
Additionally, thanks to updates in financial technology, many of the traditional roadblocks to investing such as commissions for trading and high minimum deposits are no longer things that you need to worry about.
Continue reading to learn everything that you need to know about investing in small-cap stocks.
Best Small-Cap Stocks
If you were to ask 10 different film critics what they consider to be the best movie of all time, it’s very possible that you would get 10 different answers. This doesn’t mean that any of the critics are misinformed. Instead, it just means that people base their opinions on different facts. They might all have sound arguments. However, their arguments lead them to different conclusions.
With that said, stocks work in a very similar way. There are so many different factors at play that it’s almost impossible to select one stock as the “best” stock. However, with that said, we’re always interested in sharing our research and ideas publicly. This allows you the ability to use our due diligence in order to fuel your own decisions.
With that said, here are a few of the stocks that we consider to be excellent choices:
- GameSquare – One of the top eSports marketing companies with a wide network of influencer/celebrity partnerships.
- HempFusion – A CBD brand that’s built on decades of extensive research.
- Kraken Robotics – A world leader in underwater imaging technology.
If you are interested in learning more then continue reading to get get more detail on why we feel these are some of the best small-cap stocks on the market right now.
We hope that you’ve found this article valuable when it comes to learning a little more about small-cap stocks and how they can be a valuable addition to your portfolio. To briefly summarize, small-cap stocks can be a valuable addition to your portfolio if you are looking to maximize your long-term gains. Since they do not receive a lot of attention from analysts and institutional investors, there’s potential to find small-cap stocks that are undervalued by the market. However, investing in small-cap stocks also comes with higher risk and their prices can be more volatile in the short term.
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