Small cap stocks are shares of companies with a small market capitalization. This definition of “small market capitalization” varies by country, as the size of the total capital pool/GDP can differ, and thus the respective bands that define small cap, microcap or large cap stocks can vary. Generally, publicly traded equities are considered small cap stocks if their market capitalization (“market cap”) is between $300 million to $2 billion. In contrast, microcap stocks are companies that have market caps under $300 million.
In order to determine what stocks to add to your investment portfolio, it is important to understand the advantages and benefits of investing in smaller stocks and their associated risks.
Why Invest in Small Cap Stocks and Microcap Stocks?
Small cap stocks have several advantages that can earn investors numerous benefits if the right investment is made.
Firstly, small cap stocks and microcap stocks potentially offer high returns. For example, in 1998, Amazon’s stock was priced at approximately $15 USD, which today is equivalent to $24.20 USD based on inflation. On April 2021, the stock traded at $3,365.95 USD.
Most of the time (especially in Canada) young companies and even start-ups go public far quicker than their U.S. peers. Although many of these firms generate revenues, they may not be profitable, leading to valuations that would categorize them as either small cap stocks or microcap stocks. However, good management teams that execute well formulated business strategies often build their firms to where their companies generate positive EBITDA (earnings before interest, tax, depreciation and amortization) and eventually positive net earnings. These financial milestones should translate into market cap growth for small cap stocks and microcap stocks, over the long-term, bringing the potential to outperform reference indices. For a lower upfront cost per share than what mature companies typically offer, you as an investor could end up with significant holdings in the company once it reaches a point of maturity.
Secondly, small cap stocks and microcap stocks are an excellent way to diversify your investment portfolio. Typically, small cap stocks are less in demand by larger investors due to liquidity constraints and offer more opportunities to accumulate more shares before the company becomes larger.
Thirdly, a reason for liquidity restraints is that many small cap stocks and microcap stocks are ignored by institutional investors and investment banks. The reason for this is that in order to reduce risk, many portfolio managers place restrictions on what stocks they can purchase. Often, small cap stocks and microcap stocks fall outside of these minimum market cap restrictions. Investment banks collect fees from raising capital for issuers. Small cap stocks and microcap stocks are often ignored because these issuers typically raise small amounts of capital and therefore generate lower fees for investment banks. Bigger is better when it comes to getting paid, so investment banks and research analysts tend to gravitate towards midcap stocks and large cap stocks.
This lack of interest from capital markets professionals represents an opportunity for patient investors. As management teams grow their businesses, increasing revenues, generating positive EBITDA and profits, small cap stocks and microcap stocks should see their valuations grow over time. And when these market caps grow to certain levels, institutional investors and investment banks will become interested in companies that were once small cap stocks and microcap stocks. By investing early on, patient investors can benefit from new investors and investment bank interest.
Fourthly, related to the lack of interest from institutional investors and investment banks, management teams of small cap stocks and microcap stocks are often available to speak with investors. They want more interest in their companies and their small cap stocks and microcap stocks, and will talk to investors owning small amounts of stock.
Small Cap Stocks and Microcap Stocks: Relative Performance Over Time
Small cap stocks tend to fluctuate frequently and more dramatically within shorter periods of time. This is likely due to lower overall institutional ownership. This can be compounded with lower liquidity (the ability to enter and exit a position) associated with small cap stocks and microcap stocks. Should companies with illiquid small cap stocks and microcap stocks report a positive event (better than expected profits, for example), it may be difficult for an investor to purchase shares without paying a premium price. Conversely, an investor could have difficulty exiting the same illiquid small cap stocks and microcap stocks should these companies report a negative event (a lost contract, for example).
However, over the longer term, historical data indicates that small cap stocks tend to outperform large cap stocks. In Canada, the MSCI Canada Small Cap Index indicates a 25.54% turnover and 82.79% in gross return over the last year for small cap stocks. The Russell 2000 Index, which measures small cap stocks in the United States, shows a 20% return on small cap stock investments in 2020. This momentum is predicted to continue throughout 2021 as a strong economic post-pandemic recovery is predicted.
Small Cap Fund Flows
For investors, fund flows can help indicate trends and patterns for the broader markets and provide a better sense on the longer-term trajectory of small cap stocks and microcap stocks. While fund flows do not indicate the performance of a stock itself, they help provide a better sense on the movement of money in and out an investment. Money typically flows into small cap stocks and microcap stocks during a “risk-on” period, when the economic backdrop is strong and/or the future growth potential within the economy looks promising.
Analyzing fund flows for individual companies can also help provide valuable insight and context around the valuations of small cap stocks and microcap stocks. Fund flows into a company could indicate a shared sense of optimism toward that particular business. Significant fund flows out of a company can indicate larger risk or a more cautious investor mindset. Additionally, when fund flows move fast and aggressively into a sector or individual equity, the valuations of those businesses will increase, and the shares will become more expensive (sometimes even prohibitive) to purchase.
Reach Out If You Want To Better Understand the Business of One of Our Clients
No matter where you invest your money, you want to be sure you are making the right decisions for your financial objectives, resources, constraints, and risk profile. If you are considering investing in small cap stocks or microcap stocks and are starting the diligence process, talk to our team at Sophic Capital. We cover a wide range of underfollowed and underappreciated small cap stocks that we have conducted extensive due diligence on before adding them as clients of the firm.
One of our professionals would be happy to help you determine which companies show the most promising potential for growth. Get in touch with us with any questions you have, or subscribe to our mailing list to stay in the loop on the latest trends, forecasts, and predictions.