Small-cap stocks may present attractive investment opportunities. Learn more about small-cap stocks, including their potential benefits and risks, and past performance.
There are plenty of ways you can analyse and separate stocks to help figure out which ones you might want to add to your portfolio next. One popular method is to look at market capitalisation rankings, which separate companies based on the total value of their outstanding shares.
There are three main rankings that are generally used:
- Small-cap
- Mid-cap
- Large-cap
Small-cap stocks are generally considered those that have a market capitalisation of $300 million to $2 billion. These companies tend to be younger and smaller than their mid- cap and large-cap counterparts.
This guide focuses on small-cap stocks — the potential pros and cons to investing in these stocks, how to choose which ones might be right for you and how they have generally performed in the past.
What are the potential benefits of small-caps?
There are a few potential benefits to investing in small-cap stocks. While none of these factors are guaranteed to apply to all small-caps, they can be the reason investing in these types of companies might be a good fit for you depending on your strategy and existing positions.
Room to grow
Small-caps could have more room to grow than mid-cap and large-cap stocks. Often, small-cap companies have not been around as long as mid- and large-cap companies. That can mean they have yet to make their big breakthrough and really impact the market.
Small-cap investors might be able to buy shares before a big break that potentially makes the stock’s value rise.
Fewer corporate investors
You might not have to worry about the movements of larger corporate investors and brokers when looking to invest in the best small-cap stocks. Larger institutions and investors often do not focus on smaller companies. Therefore, they are less likely to take large “buy” or “sell” positions that could drastically alter the market.
Lower prices
This partially ties into the previous point: this potential lack of large institutional interest — combined with small-cap stocks often not having the same coverage and analysis as larger stocks — can mean buying prices remain lower.
What risks are involved in investing in small-caps?
While there are potential benefits to investing in small-cap stocks, there are also some risks, just like with any other type of investing. Again, while each of these might not apply to every small-cap stock, they could play a role in helping you to make your decision.
Less liquidity
When we talk about the liquidity of small-cap stocks, what we’re talking about is how difficult or easy it might be to sell them. One of the potential small-cap positives we discussed — the relative lack of interest or knowledge in them on the part of some investors and brokers — can also be a negative, as it can be difficult to sell these stocks due to this lack of interest or knowledge.
Volatility
As many small-cap stocks are comparatively young in their business life cycle, they might not have as sturdy a foundation or the same cash flow as other businesses. With less stable footing can come less margin for error and less ability to navigate major events (such as a pandemic or other economic downturns) as easily as larger companies might.
Small-cap stocks can feel the impact of these ups and downs more than their counterparts.
Lack of information
It can be difficult to find the same level of analysis around small-cap companies that mid- and large-cap companies enjoy. For example, small-cap companies often would not have the same growth, or earnings reports or press releases.
Because of this, you might have to do a lot of manual digging and maths to uncover which potential investment opportunities might suit you.
Tip: It’s helpful to understand all of the capitalisation sizes: small-cap, mid-cap and large-cap stocks, so you can make informed investing decisions.
Do small-caps offer dividends?
Yes, there are some small-cap stocks that offer dividends. Those that do can potentially offer two great benefits that investors must sometimes choose between when allocating their capital: the reliable payment of dividends and the aforementioned growth potential of small-cap stocks.
However, the number of small-cap stocks that pay dividends generally represents a small percentage of the total number of small-cap companies.
Some small-cap stocks that pay dividends include:
- Funds management business Magellan Financial Group Limited (MFG.ASX)
- Outsourced administration service provider Link Administration Holdings Limited (LNK.ASX)
- Firearms manufacturer Smith & Wesson (SWBI)
- Food company B&G Foods Inc. (BGS)
Tip: While some small-cap stocks do offer dividends, it’s often more likely that large-cap stocks, including most blue-chip stocks, may offer more reliable payments year after year.
How do you choose small-cap stocks?
Here are some things to consider when trying to find the top small-cap companies to invest in. As you will see, some of these concepts overlap with other types of investment strategies.
Target growth
While this is something many investors try to do across a range of strategies, it can be especially important when looking at small-caps. The potential for growth is one of the biggest potential benefits of small-cap stocks.
Look for companies that could offer a new service, provide an existing service better, or which could be set to take advantage of changing circumstances or regulations in their respective industry.
Put in the work
With generally less traditional reports and information released, it often takes a bit of digging to unearth quality small-cap investing opportunities.
But if you are willing to do your research — reading market news and analysis, staying up to date on small business news outlets and tracking company performance — you could put yourself in a better position to choose your next target.
Follow the money
Available cash and cash flow can be a good barometer for a small-cap company. It could mean they have a better chance to weather some storms and also might show they are in a good position to become cash positive sooner rather than later.
You can look at a variety of factors, including total asset value, price earning ratio (also known as PE ratio) and overall incomings and outgoings. Learning the fundamentals of research can help you to improve your investing decisions and better understand market up or downturns.
How have small-caps performed historically?
Some believe the chance for larger growth margins means small-caps often outperform large- caps. And, in general, small-cap stocks have outperformed large-cap stocks in the past. But, as with many aspects of investing, different events and market environments can change that.
In bear markets, following large economic downturns, many small-caps have bounced back better than their larger counterparts. Some say reasons for this include more impactful recovery funding by the government and the wider range of industries and sectors found within the small-cap landscape.
But, there are also times when large-caps outperform their smaller counterparts, as in the Dot-Com Bubble of the 1990s. However, small-cap companies started performing better once that bubble burst in 2000.
As with other types of investments, small-caps come with a variety of benefits and risks. These comparatively small companies can be a great way to diversify your portfolio and could provide an entryway into a sector or industry at an agreeable price point.
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FAQs
- What are different ways to analyse stocks?
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It’s a big question and you can spend a long time enhancing your knowledge through the eToro Academy. But, in summary, five of the most common methods are:
1. Fundamental analysis — where you study valuation and growth indicators
2. Technical analysis — where you study objective information to identify patterns
3. Study of management — you can find out much through close attention to the management team, their announcements, plans and personal trading.
4. Your own experience — consider your reactions to everyday brands you interact with, and whether their values and performance hold promise for you.
5. Newsletters — there are many email newsletters with advice on picking stocks.
- What is institutional interest?
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Institutional interest is, in contrast to individual traders and investors, very large companies, organisations, investment banks and so on which often trade shares in large parcels and high volumes. They provide liquidity to the market and often set the trends.
- What is a business lifecycle?
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Every business goes through a range of stages, defined variously as four, five or even seven stages. Forbes suggests the basic steps: start-up, growth, maturity and either decline or renewal and rebirth.
This information is for educational purposes only and should not be taken as investment advice, personal recommendation, or an offer of, or solicitation to, buy or sell any financial instruments. This material has been prepared without regard to any particular investment objectives or financial situation and has not been prepared in accordance with the legal and regulatory requirements to promote independent research. Any references to past performance of a financial instrument, index or a packaged investment product are not, and should not be taken as a reliable indicator of future results. eToro makes no representation and assumes no liability as to the accuracy or completeness of the content of this guide. Make sure you understand the risks involved in trading before committing any capital. Never risk more than you are prepared to lose.