Small Cap Investing

A focus on finding small cap companies with great fundamentals and big growth prospects.

A small-cap stock is a stock of a publicly-traded company whose market capitalization ranges from $300 million to approximately $2 billion, explains Corporate Finance Institute. The word “cap” in this term refers to a company’s market capitalization.

Savvy investors cannot afford to overlook small-cap growth companies. Although, there are several pros and cons of investing in small-cap stocks that must be considered.

Small-cap companies, in general, tend not to get the same kind of publicity as their large-cap siblings. They aren’t going to lead a segment on CNBC or the home page of the Wall Street Journal on a daily basis.

With smaller market capitalizations, small-cap companies tend to fly under the radar.

The Rise of Small-Cap Stocks

Reasons that people may invest in small-cap companies are capital appreciation — they think the stock price will go up and dividends — where the company pays you to hold it.

But some of these are solid companies and excellent small-cap stocks to buy.

Small-cap equities are more sensitive to the economy (inflation, rising interest rates and dollar strength), so a robust economic rebound would favor them.

Small-cap stocks are popular among investors because of their potential for providing better returns in the long term relative to their large-cap peers.

The advantages of investing in small-cap stocks are:

1. Growth potential – Relative to bigger companies, small-cap companies show significantly higher growth potential. For small-cap companies, it is easier to grow significantly their operational and financial base than is the case for most large-cap stocks.

Picking the right small-cap stock can turn into a profitable investment.

2. High probability of inefficiencies in the market – Information about the small-cap stocks is harder to find compared to large and mid-cap companies. Analysts typically give little attention to these companies; thus, there is a high probability of improper pricing of small-cap stocks. This situation creates vast opportunities for investors to leverage the inefficiencies in market pricing and earn a great return on their investments.

3. Financial institutions do not push prices up – Financial institutions, including mutual and hedge funds, should comply with certain regulations that do not allow them to invest heavily in small-cap stocks. For this reason, it is unlikely that the stock price will be artificially pushed up because of large investments from major financial institutions.

Nevertheless, there are some disadvantages of investing in small-cap stocks:

1. High risk – Investing in small-cap stocks involves higher risk. First, small-cap companies may have an unreliable and faulty business model which can result in company’s management not being able to adjust the business model, and can result in poor operational and financial results. And, small-cap companies usually have less access to new capital and new sources of financing. Due to this reason, it is more likely that the company will not be able to bridge gaps in its cash flows or expand the business because of the inability to undertake the necessary investments.

2. Low liquidity – Small-cap stocks are less liquid than their large counterparts. Low liquidity results in the potential unavailability of the stock at a good price to purchase or it may be difficult to sell the stocks at a favorable price. Low liquidity also adds to the overall risk of the stock.

3. Time-consuming – Investing in small-cap stocks can be a time-consuming activity. Due to the under-coverage of small-cap stocks by financial media, institutions and analysts, the amount of available research on small-cap companies is usually limited.

Moreover, small cap technology and all small cap stocks are discounted to a great degree by investors in a rising interest rate environment, purely due to the fact that they have the bulk of potential earnings and cash flow far out into the future. The higher long-term rates are, the less those future earnings and cash flow are worth. This goes for virtually all unprofitable growth tech stocks.

Essentially, small-cap stocks may provide investors with an opportunity to earn a substantial return on their investments. However, this type of investing should be approached with caution as small-cap stocks are often risky and volatile.

References:

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