by Ian Harvey
July 27, 2019
Small-cap stocks are securities that are tied to companies whose market values often fall between $300 million and $2 billion. Stocks with a market cap below $300 million are referred to as micro caps, and those below $50 million are called nano caps.
Small-cap stocks can be found trading on any exchange; although the majority of them are found on the Nasdaq or the OTCBB because of those exchanges' more lenient listing requirements.
Adding small-caps to your investment portfolio could be a good idea, especially if you’re interested in building long-term wealth.
Understanding the difference between “Penny” stocks and “Small-Cap” stocks…..
A penny stock and a small-cap stock represent the shares of a company with low market capitalizations. However, there is a distinction between the two. A penny stock trades at a low price and low market capitalization, and it often trades over the counter. A small-cap stock is based on a company's market capitalizations and not its stock prices.
In the past, penny stocks were considered any stocks that traded for less than one dollar per share. The U.S. Securities and Exchange Commission (SEC) has modified the definition to include all shares trading below five dollars.
Penny stocks are usually associated with small companies and trade infrequently meaning they have a lack of liquidity or ready buyers in the marketplace.
Due to their lack of liquidity, wide bid-ask spreads or price quotes, and small company sizes, penny stocks are generally considered highly speculative.
Positive Factors for Investing in Small-Caps…..
1. Huge growth potential…..
Most successful large-cap companies started at one time as small businesses. Small-caps give the individual investor a chance to get in on the ground floor of younger firms that are bringing new products and services to market or entering new markets altogether before a company explodes in size and its stock value skyrockets..
Because small-caps are just companies with small total values, they have the ability to grow in ways that are simply impossible for large companies.
Between 1979 and 2015, small-cap stocks in the Russell 2000 index outperformed large-cap stocks in the S&P 500 20 times within 37 years. In terms of the average annual return on investment, small- and large-cap companies’ stocks were virtually neck and neck, with the S&P 500 paying investors back 11.7% annually versus the 10.3% annual returns generated by the Russell 2000 index. In the long run, investing in smaller cap stocks may be just as profitable (if not more profitable) than investing in larger ones.
3. Individual Investors Advantage over Institutional Investors…..
The SEC places heavy regulations on Institutional Investors which makes it difficult for the funds to establish positions of any significant size to be profitable. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do.
4. Under the “Radar”…..
Small-caps usually have very little analyst coverage and therefore gain little to no attention from Wall Street. Therefore, individual investor are offered an opportunity to profit from the inefficiencies caused by the lack of coverage, as the small cap universe is so under-reported or even undiscovered, there is a high probability that small cap stocks are improperly priced, leaving the door open to the astute individual trader.
Having a diverse portfolio can provide you with some insulation from market volatility. By investing in small-cap stocks directly, you can create some balance in your portfolio that may not have been there before.
Risks to Consider…..
1. Volatility and Risk…..
Quite often a small-caps worth is based on its ability to generate cash. Their smaller balance sheets are less insulated from changes in the economy and poor economic conditions. As well, small-cap stocks tend to have much smaller customer bases, so their prospects are more uncertain and tied to a specific regional area. As a result, many small-cap stocks are unable to survive through the rough parts of the business cycle.
Also, small-caps are also more susceptible to volatility, simply due to their size; it takes less volume to move prices.
2. Amount of Time for Research…..
Most times there is very little information when trying to research a small-cap stock for an investment. Financial ratios and growth rates are widely published for large companies, but not for small ones. There are few analyst reports, or media coverage, on which you can start to construct a well-informed opinion of the company.
Therefore, the onus is on the individual to actually do the number-work to decide the viability of an investment in a particular small-cap stock.
Investing a portion of your money in small cap stocks will help a trader have a better diversified portfolio and possibly earn higher returns.
As small-cap-stocks are normally more risky than large-cap, well establish companies, it is important to take into account your risk tolerance when deciding how large of percent of your portfolio should be invested in small cap stocks. Since small-caps tend to earn higher returns, they also tend to be more volatile as well.