Small cap stocks have a bad reputation. The media usually focuses on their negative side, saying they are risky, frequently fraudulent and lacking in quality that investors should demand in a company. Certainly these are all valid concerns for any company, but big, large-cap companies have also fallen prey to issues of internal fraud that virtually destroyed shareholder interest (think Enron and Worldcom). Clearly, company size is by no means the only factor when it comes to investors getting scammed. In this article we'll lay out some of the most important factors comprising the good and the bad of the small-cap universe. Knowing these factors will help you decide whether investing in smaller-capitalized companies is right for you. (For background reading on the benefits of small caps, see Small Caps Boast Big Advantages.)

Background

Before we get into the pros and cons of small caps let's just recap (no pun intended) what exactly we mean. The term small caprefers to stocks with a small market capitalization, between US $250 million and $2 billion. Stocks with a market cap below $250 million are referred to as micro caps, and those below $50 million are called nano caps. Small-cap stocks can trade on any exchange. although a majority of them are found on the Nasdaq or the OTCBB because of those exchanges' more lenient listing requirements.

It is important to make the distinction between small caps and penny stocks, which are a whole different ball game. It is possible for a stock to be a small cap and not a penny stock. In fact, there are plenty of small caps trading at more than $1 per share, and with more liquidity than the average penny stock. (Learn more in What is the difference between a penny stock and a small cap stock?)

Why Invest In Small Cap Stocks?

While small caps have their negative attributes – which we'll get into later on – they have a number of positive factors too. Below we have outlined three of the most compelling reasons why small caps deserve representation in many investors' portfolios.

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. Everyone talks about finding the next Microsoft, Wal-Mart or Home Depot, because at one point these companies were small caps – diamonds in the rough if you will. Had you possessed the foresight to invest in these companies from the beginning, even a modest commitment would have ballooned into a tidy sum.

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. A large company, one with a market cap in the $1 billion to $2 billion range, doesn't have the same potential to double in size as a company with a $500 million market cap. At some point you just can't keep growing at such a fast rate or you'd be bigger than the entire economy!

Mature companies have limited organic growth rates because they already address a larger proportion of their target market. Any new product or service represents a smaller proportion of total revenue than the established product offering. For these reasons, earnings and cash flow growth in large-cap stocks can be limited, unless their corporations acquire other firms.If you're seeking high-growth companies, small caps are the place to look.

2. Most mutual funds don't invest in them
It isn't uncommon for mutual funds to invest hundreds of millions of dollars in one company. Most small caps don't have the market cap to support this size of investment. In order to buy a position large enough to make a difference to their fund's performance, a fund manager would have to buy 20% or more of the company. The SEC places heavy regulations on mutual funds that make it difficult for the funds to establish positions of this size. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do. When institutions do get in, they'll do so in a big way, buying many shares and pushing up the price.

3. They are often under-recognized
This third attribute of small caps is very important. What we are saying here is that small caps often have very little analyst coverage and garner little to no attention from Wall Street. What this means to the individual investor is that, because the small cap universe is so under-reported or even undiscovered, there is a high probability that small cap stocks are improperly priced, offering an opportunity to profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market. (Find out how to spot winners in Spot Hotshot Penny Stocks.)

The Drawbacks to Small Cap Investing

Despite the fact that small caps demonstrate attractive characteristics, they are not without inherent drawbacks. These include:

1. Risk

In terms of equity categories based on market capitalization, small caps are the fourth riskiest group out of five. (The other categories from least to most risky are mega caps, large caps, mid caps, small caps and micro caps.)

Often much of a small cap's worth is based on its propensity to generate cash, but in order for this to happen it must be able to scale its business model. This is where much of the risk comes in. Not many companies can replicate what U.S. retail giant Wal-Mart has done, expanding from essentially a mom-and-pop store in Arkansas to a nation-wide chain with thousands of locations. Their smaller balance sheets are less insulated from changes in the economy and poor economic conditions. Additionally, 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.

Small caps are also more susceptible to volatility, simply due to their size; it takes less volume to move prices. It's common for a small cap to fluctuate 5% or more in a single trading day, something some investors simply cannot stomach. And since these stocks have less liquidity (the big institutional investors can't or won't traffic in them, remember), someone may not be able to exit a position at the market price, and this possibility is greater during a market panic.

So, the money you invest in small caps should be money you can expose to a much higher degree of risk than that of proven cash-generating machines like large caps and blue chips.

2. Time
Finding time to uncover that small cap is hard work – investors must be prepared to do some serious research, which can be a deterrent. Financial ratios and growth rates are widely published for large companies, but not for small ones. You must do all the numbers-crunching yourself, which can be very tedious and time-consuming. This is the flip side to the lack of coverage that small caps get: There are few analyst reports on which you can start to construct a well-informed opinion of the company.

And because there is a lack of readily available information on the small-cap company, compared to large caps that are regularly covered by the media, you won't hear any news for weeks from many smaller firms. By law these companies must release their quarterly earnings, but investors looking for more information will be hard-pressed to find anything. (To read more, see How To Evaluate A Micro-Cap Company.)

The Bottom Line

The primary advantage of investing in small-cap stocks is significant upside growth potential that is unmatched by mature companies with large market capitalizations.

Merger and acquisition activity also provides an opportunity for small-cap investors. Small caps are acquired more frequently than larger companies; large companies often can enter new markets or gain intellectual property by acquiring smaller businesses. Acquisitive companies usually pay a premium to market price to acquire growth firms, leading to share price appreciation as soon as a deal is announced publicly.

There is certainly something to be said for the growth opportunities that small cap stocks can provide investors. However, along with these growth opportunities come increased risk. Small-cap investors sacrifice stability for potential. If you are able to take on additional levels of risk, exploring the small cap universe is something you should look into. Alternatively, if you are extremely risk averse, the rollercoaster ride that is the stock price of a small cap company may not be appropriate for you.

In short, the money you invest in small caps should be money you can expose to a much higher degree of risk than that of proven cash-generating machines like large caps and blue chips. But if you're sold, the next step is to learn about Valuing Small-Cap Stocks and  How to Diversify with Small-Cap Stocks.

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