Small-cap stocks are defined as stocks that have a market capitalization between $300 million and $2 billion. When it comes to classifying stocks, small-cap stocks are one of four categories:
- Micro-cap stocks
- Small-cap stocks
- Mid-cap stocks
- Large-cap stocks
- Mega-cap stocks
You can typically determine whether a company qualifies as a small-cap stock by multiplying the total number of shares by the price of those shares. Knowing this formula can also help you determine any of the other missing pieces depending on the information that you have.
For example, let’s say that you were examining the underwater robotics and electric battery manufacturing company Kraken Robotics. A quick visit to Google Finance shows us that Kraken Robotics’ shares are currently trading at $0.32. It also tells us that Kraken Robotics has a market cap of $81.5 CAD.
You can now use this information to determine how many shares outstanding Kraken Robotics must have.
$81.51 M = Total # of Shares Outstanding X $0.32
In this case, Kraken Robotics must have approximately 254.72 million shares outstanding (81.51M / $0.32 = 254.72 M). In general, market capitalization is just one of the methods used to value a company.
So Why Does This Matter?
Understanding this type of information is incredibly important when it comes to making educated investment decisions. Measurements like small, mid, or large-cap are commonly used to help classify different types of stocks based on the value of the company. Even if you know nothing about the company, you can quickly assume different things based on the value of their stock.
Again, small-cap stocks, like Kraken Robotics, are stocks that have a market capitalization between $300 million and $2 billion. Here is the complete breakdown of how market capitalization ranges are broken down:
- Micro-cap stock = <$300 million
- Small-cap stock = $300 million- $2 billion
- Mid-cap stock = $2 billion – $10 billion
- Large-cap stock = $10 billion – $200 billion
- Mega-cap stocks = >$200 billion
A great example of a successful small-cap stock is Amazon in the early 2000s. During this time (after the tech bubble popped) Amazon was trading for just under $10/share. This classified it as a small-cap stock. However, over the following two decades, Amazon has both expanded and diversified its business, growing out of the online book retailer it was into the mega-cap eCommerce goliath that we know today.
While Amazon is obviously a very successful story, not all companies are able to transform from small-cap to mega-cap and oftentimes large and mega-cap stocks don’t start as small-cap stocks. For example, when the ride-hailing app Uber went public it started trading at $42/share. Uber sold enough shares during its IPO to bring in $8.1 billion, which valued the company at around $75 billion. Despite being public for only one day, Uber was instantly a large-cap stock.
That said, let’s imagine that the U.S. government passed a law that made ridesharing illegal in every state but Rhode Island. Uber’s business would now be confined to one state and its revenues would likely drop quite drastically. Its stock price would follow until Uber’s shares were worth considerably less than they are today, likely leading to it being defined as a small-cap stock.
It’s important to note that the value of a company is not set in stone. Companies are constantly adapting to the changing business landscape. As their business grows or shrinks, so does their market capitalization. Stock investing is all about identifying which companies are on a path for success or failure and taking the appropriate action.
Now, let’s take a look at a few of the traits of small-cap stocks.
Common Traits of Small-Cap Stocks
One reason that investors like to classify stocks based on their market capitalization is that this quickly gives them an idea of what to expect from the stock. It’s a little bit like how sports analysts refer to first-year professional players as “rookies” compared to the players who have been around much longer, which we lovingly refer to as “veterans”. This classification doesn’t mean that a rookie can’t outperform a veteran. It also doesn’t mean that a veteran can’t still compete with a younger player. These are just terms to help classify different players.
Just like most sports analysts get excited about the future career of rookies, many stock analysts get excited about the growth potential of small-cap stocks.
In general, small-cap stocks are known for having better growth potential compared to large or mega-cap stocks. This is because it’s inherently easier for a business to grow a $5 million annual revenue by 20% than it is to grow $5 billion of revenue by 20%.
To visualize this, imagine trying to grow your own personal income. If you make $50,000 per year then you only need to earn an extra $10,000 to achieve 20% growth. However, if you make $5 million per year then you’ll need to earn an additional $1 million to achieve this same level of growth.
Due to this, small-cap stocks usually have much more room to grow over the long term.
With investing, it’s generally accepted that anytime you have a chance to earn a higher return you’re also going to take on more risk. This holds true for small-cap stocks.
Small-cap stocks are generally businesses that are less established and diversified. This means that events like losing one big client can have a devastating impact on their business. Due to this, small-cap stocks are generally more volatile.
Lack of media attention
The last thing to note about small-cap stocks is that they generally don’t receive a lot of media or analyst attention. Instead of small-cap stocks, analysts will focus the bulk of their attention towards massive companies like Tesla (Nasdaq: $TSLA) or Apple (Nasdaq: $AAPL).
Due to this, there is a high potential for discovering asymmetric information with small-cap stocks. Asymmetric information is information you’ve discovered that other investors may not have realized yet. If you can identify a small-cap stock that has unrealized potential then it gives you a good chance to outperform other investors.