Unfortunately, small cap stocks have a bad reputation. The media usually focuses on their negative side. They say that small cap investing is too risky. One frequently hears claims that fraud is rampant. They also say small caps lack the quality that investors should demand in a company. Indeed, these are all valid concerns for any company.

However, large cap companies have also fallen prey to issues of internal fraud that virtually destroyed shareholder interest. Remember Enron? Clearly, company size is by no means the only factor when it comes to scams. In this article, we'll lay out some of the most critical factors. We will look at both the good and the bad in the small cap universe. Knowing these factors will help you decide whether investing in small cap companies is right for you.

Key Takeaways

  • Individual small cap stocks offer higher growth potential, and small cap value index funds outperform the S&P 500 in the long run.
  • Small caps also experience higher volatility, and individual small companies are more likely to go bankrupt than large firms.
  • The opportunities of small caps are best suited to investors who are willing to accept more risk in exchange for higher potential gains.

Background

Before we get into the pros and cons of small caps, let's recap what exactly we mean by small cap. The term small cap refers to stocks with a small market capitalization, between $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. However, the majority of them are found on the Nasdaq or the OTCBB. That should not be surprising, as those exchanges have more lenient listing requirements.

It is essential to make the distinction between small caps and penny stocks, which are a whole different ballgame. 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 far more than $1 per share. William J. O'Neil and Nicolas Darvas made their fortunes in small caps in part by focusing on companies with high share prices.

Much of the bad publicity for small companies comes from penny stocks. Investors can avoid most of those issues by investing in small companies with higher share prices.

Advantages of Small Cap Investing

While small caps have well-known risks, they also offer significant benefits that many investors do not realize.

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. These younger firms are bringing new products and services to the market or creating entirely new markets. Everyone talks about finding the next Microsoft, Amazon, or Netflix because these companies were once small caps. Had you possessed the foresight to invest in them from the beginning, even a modest commitment would have ballooned into a small fortune.

Because small caps are just companies with low total values, they can grow in ways that are simply impossible for large companies. A large company, one with a market cap in the $1 trillion range, doesn't have the same potential to grow as a company with a $1 billion market cap. Amazon isn't going to be the next Amazon. At some point, the company can't keep growing so fast because it can't be bigger than the entire economy!

Large Mutual Funds Don't Invest in Them

It is common for big mutual funds to invest hundreds of millions of dollars in one company. Most small caps don't have the market cap to support these large investments. In order to buy a position large enough to make a difference in their fund's performance, a fund manager would have to buy 20% or more of the company. The Securities and Exchange Commission (SEC) places heavy regulations on mutual funds that make it difficult for the funds to establish positions of this size. That gives an advantage to individual investors who can 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.

Small Cap Value Index Funds

While individual small cap stocks can be risky, small cap value stocks as an asset class have outperformed the S&P 500 in the long run. That is not a tip, a hunch, or a guess. The outperformance of small cap value was demonstrated by the Fama and French Three Factor Model. If you are still skeptical, remember that Fama won a Nobel Prize for his work on efficient markets. What we are saying here is that small cap value stocks often have very little analyst coverage and garner little to no attention from Wall Street. That makes them undervalued and gives them higher returns.

While picking winners is difficult in this category, the best small cap value index funds make it easy to boost your returns. It is true that individual small undervalued companies are more likely to fail than large caps. However, investing in a small cap value index fund is actually much safer than buying any single large cap stock. What is more, it is also likely to produce higher returns.

Disadvantages of Small Cap Investing

The drawbacks of small caps are familiar to most investors, but they are still worth going over.

Risk

There is no denying that investing in a small company carries more risk than investing in a blue chip stock. Often, much of a small cap's valuation is based on its potential to grow. In order for this to happen, it must be able to scale its business model. That is where much of the risk comes in. Not many companies can replicate the expansion of U.S. retail giant Amazon.

Small cap companies tend to have much smaller customer bases, so their prospects are more uncertain and often tied to a specific geographical 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 due to their size. It takes less volume to move prices. It is common for the price of a small cap stock to fluctuate 5% or more in a single trading day. That is something that many investors simply cannot stomach. Since these stocks often have less liquidity, it is also more difficult to exit a position at the market price.

Time

Finding the time to uncover quality small caps 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 much of the number-crunching yourself, which can be very tedious. That is the flip side to the lack of coverage that small caps get. There are fewer analyst reports for constructing a well-informed opinion of the company.

The Bottom Line

The primary advantage of investing in individual small cap stocks is the significant upside growth potential that is unmatched by larger companies. Small cap value index funds also offer a way for passive investors to boost returns.

Merger and acquisition activity provides another opportunity for small cap investors. Small caps are acquired more frequently than larger companies. Large companies can enter new markets or gain intellectual property by buying smaller businesses. Acquisitive companies usually pay a premium to acquire growth firms, leading to profits as soon as a deal is announced publicly. Undervalued small companies can also make tempting takeover targets, especially when they are selling for below book value.

However, these opportunities to profit also come with some risks. Small cap investors sacrifice stability for potential. If you can take on additional levels of risk, exploring the small cap universe might be for you. If you are extremely risk-averse, the roller coaster ride that is the stock price of a small cap company may not be appropriate for you.