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What is 'Small Cap'

Small cap is a term used to classify companies with a relatively small market capitalization. A company's market capitalization is the market value of its outstanding shares. The definition of small cap can vary among brokerages, but it is generally a company with a market capitalization of between $300 million and $2 billion.

BREAKING DOWN 'Small Cap'

One of the biggest advantages of investing in small-cap stocks is the opportunity to beat institutional investors. Because mutual funds have restrictions that limit them from buying large portions of any one issuer's outstanding shares, some mutual funds would not be able to give the small cap a meaningful position in the fund. To overcome these limitations, the fund would usually have to file with the SEC, which means tipping its hand and inflating the previously attractive price.

Keep in mind that classifications such as "large cap" or "small cap" are only approximations that change over time. Also, the exact definition can vary between brokerage houses.

Calculating Market Capitalization

To calculate a company's market capitalization, multiply its current share price by its number of outstanding shares. For example, as of June 2016, Sonic Corp., which owns the Sonic Drive-In chain, has 48.55 million shares outstanding and a share price of $28.16. Therefore, its market capitalization is approximately $1.37 billion. Because this figure is under $2 billion, most brokerages consider Sonic Corp. a small-cap company as of 2016.

Investing in Small Cap vs. Large Cap Companies

As a general rule, small-cap companies offer investors more room for growth but also confer greater risk and volatility than large-cap companies, which have market capitalization of $10 billion or greater. With large-cap companies, such as General Electric and Boeing, the most aggressive growth tends to be in the rear-view mirror, and as a result, such companies offer investors stability more than big returns that crush the market.

Historically, small-cap stocks have outperformed large-cap stocks. Having said that, whether smaller or larger companies perform better varies over time based on the broader economic climate. For example, large-cap companies dominated during the tech bubble of the 1990s, as investors gravitated toward large-cap tech stocks such as Microsoft, Cisco and AOL Time Warner. After the bubble burst in March 2000, small-cap companies became the better performers until 2002, as many of the large-caps that had enjoyed immense success during the 1990s hemorrhaged value amid the crash.

Investors wanting the best of both worlds might consider mid-cap companies, which have market capitalizations between $2 billion and $10 billion. Historically, these companies have offered more stability than small-cap companies yet confer more growth potential than large-cap companies.

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