How to Invest in Small Cap Stocks

Key Points

• Small-cap stocks have a market capitalization between $300 million and $2 billion.
• Small caps are often newer or developing companies with volatile stocks.
• Investing in small caps can produce big winners, but you also must have the proper risk appetite.

Starting small is usually good advice when beginning a new endeavor. If you’re trying to get back in shape, a quick run or light workout is a better starting point than a marathon. However, that logic is counterintuitive when it comes to stocks. Bigger stocks tend to be safer and less volatile, while small ones can move wildly from session to session. Small-cap investing isn’t for the risk-averse, but in this article, we’ll explain the pros and cons of buying small companies and how to spot potential winners amidst a sea of unknown firms.

What Are Small-Cap Stocks?

A small cap is a public company with a market cap between $300 million and $2 billion. While a multiple billion-dollar valuation might seem significant, consider that some of the biggest U.S. equities, such as NVIDIA and Microsoft, have multi-trillion-dollar market caps. 

Small caps are often new to public markets, giving them plenty of upside potential and outsized risk. Analyst coverage on small caps is often light, so personal due diligence is necessary. But this can be a win for investors if they discover a diamond in the rough that hasn’t received analyst coverage.

Benefits of Investing in Small-Cap Stocks

Small-cap investing can be volatile, but there are benefits for investors with the proper risk tolerance. 

Higher Growth Potential

Over long periods, small caps can produce outsized returns because many of them have outstanding growth potential. Small caps are generally the place to look if you want to ‘get in early’ on exciting companies.

Diversification Opportunities

Index funds that track the S&P 500 or NASDAQ 100 exclude small caps. This strategy has performed well over the last few years, but owning a combination of small and large companies provides an extra level of diversification.

Market Inefficiencies

Small companies also have small followings from analysts. While large caps frequently have dozens of professionals reporting and researching them, small caps fly under the radar. This can be a double-edged sword since reliable info is scarce, but it could also result in finding a big winner before the market gurus.

Risks of Small-Cap Investing

Here are some of the risks to consider when adding small caps to your portfolio:

Higher Volatility

Prepare for a rollercoaster ride as small caps frequently make volatile moves on low volume or minimal news.

Limited Resources

Large companies often have access to better rates, more affordable capital, and government officials, while smaller companies lack these resources and perks.

Potential for Loss

The small-cap sector is often a graveyard for once-promising companies. If a large cap goes bankrupt, it's a significant news story. But a small-cap bankruptcy? That’s just a Tuesday in many market circles.

Risk Management Tips

1. Diversify Your Portfolio: Never put all your capital into a single stock, especially a volatile small cap.

2. Allocate Appropriately: Keep the volatility of your overall portfolio low by carving out a chunk of capital for small caps, but keep it tiny.

3. Research Thoroughly: Small-cap stocks have minimal analyst coverage, so you must dig through the press releases, news reports, and financial data yourself.

Who Should Invest in Small-Cap Stocks?

Ask yourself the following questions to help determine if investing in small-cap stocks is right for you:

1. Are you seeking high-growth opportunities?

If you want to make outsized gains in the market, turning to small caps can help realize those goals. Small-cap stocks can produce massive profits in short timeframes if acquired, win a government contract, or perform a successful trial.

2. How well can you tolerate risk and volatility?

If you can hold your hand steady while watching your portfolio bounce around wildly, you might have the mindset for small-cap investing.

3. Is your portfolio already diversified?

Small-cap stocks work best as part of a diversified investment strategy. Adding small caps to the mix can diversify your returns if you have a portfolio loaded with large-cap stocks that move primarily in lockstep.

4. What is your investment timeline?

Patience is required for success in small caps. Yes, some companies become big winners overnight, but mostly, it's a slow and steady grind higher (with inevitable setbacks along the way).

Who Should Avoid Small-Cap Stocks?

Small caps aren’t suitable for every investor. Here are some investors who are better off passing on an investment in a small cap company:

• Conservative Investors: If capital preservation or income generation are more important goals for you than portfolio growth, small caps might be a bad deal since they’re very volatile and rarely pay dividends.
• Short-Term Traders: If you need your capital back in the next few months or years, investing in small caps is overtly risky since you might be forced to sell during a particularly nasty downturn. This is true of all equities, but doubly so with small caps.
• Passive Investors: Small-cap investing requires due diligence and constant market monitoring. If you want to “set it and forget it,’’ you should use large caps, dividend payers or index funds, not small and volatile companies.
• Investors with Limited Risk Tolerance: Don’t get in line for the ride if you can’t handle the volatility. Investors with low-risk tolerances should avoid small caps since they will likely compound mistakes instead of gains.
  

How to Identify High-Potential Small-Cap Stocks

Finding the right small-cap stocks requires thorough research and analysis. These stocks can offer significant upside potential, but not all small caps are created equal. Here are a few techniques to help identify quality small-cap opportunities: 

Analyze Financial Fundamentals 

Financial metrics, such as revenue growth, gross margins, debt ratios, cash flow and sales costs, are good places to start when evaluating small caps. Intrinsic value is another fundamental method; look at P/E and P/S ratios, enterprise value, or other metrics that indicate the company may be undervalued. Compare these metrics to other companies in the sector or industry; this will cut out stocks with empty hype.

Research Industry Trends

Small caps exist in every sector, so focus on those with high growth potential, such as cloud computing, artificial intelligence, or renewable energy. Follow market trends and regulatory changes that could influence specific industries, especially since small caps often have less sway with government officials.

Use Stock Screeners

MarketBeat can simplify your research with our stock screeners. Search through price ratios, technical signals, earnings data, or valuation metrics with just a few clicks. Advanced filtering options can uncover undervalued stocks with growth potential or solid fundamentals.

Study Management Teams

Research the C-suite and make sure the team has a history of maintaining shareholder interests. Earnings calls and press releases are places where small caps often try to overhype and underdeliver. Ensure company communications are clear and not filled with hyperbole or hopeful reassurances. Insider buying can often be a clue to the company’s future. Confident executives are likelier to buy more stock, so increased insider buying is often worth evaluating.

Evaluate Competitive Advantages

Look for companies attempting to disrupt incumbents with technological improvements or unique products and services. Even the most clever new product can fail to scale. Make sure the company can differentiate itself in competitive markets.

Strategies for Investing in Small-Cap Stocks

Want to get started with small-cap investing? Here are four strategies to consider: 

1. Long-Term Approach 

A buy-and-hold strategy allows investors to ride out market fluctuations and benefit from long-term growth. Holding a diverse collection of small caps for years or even decades can help capture the significant upside potential that some of these companies offer.

2. Dollar-Cost Averaging

Instead of trying to time the market, invest a fixed amount at regular intervals—weekly, monthly, or quarterly. This strategy helps smooth out price fluctuations by automatically buying more shares when prices are low and fewer when prices are high. It also reduces the emotional impact of volatility, which is common in small-cap stocks.

3. Consider using ETFs

If researching and picking individual small-cap stocks seems overwhelming, exchange-traded funds (ETFs) and mutual funds focused on small caps can be an easier way to gain exposure. Funds like the Schwab US Small-Cap ETF (NYSEARCA: SCHA) or iShares Russell 2000 ETF (NYSEARCA: IWM) provide instant diversification across many small companies, reducing the risks associated with investing in just a few individual stocks.

4. Combine Small Caps with Other Investments

To manage the higher risks that come along with small-cap investing, allocate only a portion of your portfolio to small caps while maintaining a diversified mix of large- and mid-cap stocks. This balance helps reduce volatility while still allowing for exposure to high-growth opportunities.

Small Cap Stocks: Not For the Faint of Heart

Small-cap stocks can reward with substantial returns, but the risks and volatility of these assets make them unappealing to certain investors. To invest for success, you must have a clear strategy and perform ample research. However, with patience and discipline, a small-cap investment strategy can be one of the most profitable market endeavors. 

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