What Are Small-Cap Stocks, and Are They a Good Investment?

What Is a Small-Cap Stock?

A small-cap stock is a stock from a public company whose total market value, or market capitalization, is about $300 million to $2 billion. The precise figures vary.

Small-cap stock investors are generally looking for up-and-coming young companies that are growing fast. That is, they're looking for the large-cap stocks of the future.

Key Takeaways

  • A small-cap stock is generally that of a company with a market capitalization of between $300 million and $2 billion.
  • Small-cap stock investors seek to beat institutional investors by focusing on growth opportunities.
  • Small-cap stocks historically have outperformed large-cap stocks but are also more volatile and riskier.

Small Cap Stock

Understanding Small-Cap Stocks

The "cap" in small-cap stands for capitalization. The term in its entirety is market capitalization.

This is the market's current estimate of the total dollar value of a company's outstanding shares. To calculate a company's market capitalization, multiply its current share price by the number of outstanding shares.

Classifications such as "large-cap" or "small-cap" are approximations that change over time. Furthermore, the precise definition of small-cap stocks vs. large-cap stocks may vary among brokers.

One misconception about small-cap stocks is that they are startups or brand new companies. In reality, many small-cap stocks are of companies that are well-established businesses with strong track records and great financials. And because they are smaller, small-cap stock share prices have a greater chance of growth.

Small-Cap Stock vs. Large-Cap Stock

As a rule, small-cap stock companies offer investors more room for growth but also bring greater risk and volatility than large-cap stock companies.

A large-cap offering has a market capitalization of $10 billion or higher. For large-cap stock companies such as General Electric (GE) and Coca-Cola Co. (KO), aggressive growth may be in the rear-view mirror. Such companies offer investors stability and dividends but rarely fast growth.

Historically, small-cap stocks have outperformed large-cap stocks. That said, whether smaller or larger companies perform better varies over time based on the broader economic climate.

For example, large-cap stock companies dominated during the tech bubble of the 1990s, as investors gravitated toward stocks such as Microsoft (MSFT), Cisco (CSCO), and AOL Time Warner. After the bubble burst in March 2000, small-cap stock companies became the better performers, as many of the large caps hemorrhaged value in the crash.

One advantage of investing in small-cap stocks is the opportunity to beat institutional investors. Many mutual funds have internal rules that restrict them from buying small-cap stock companies. In addition, the Investment Company Act of 1940 prohibits mutual funds from owning more than 10% of a company's voting stock. This makes it difficult for mutual funds to build a meaningful position in small-cap stocks.

A stock smaller than a small-cap is known as a micro-cap. That is a publicly-traded company with a market capitalization of about $50 million to $300 million.

Small-Cap Stock vs. Mid-Cap Stock

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

However, for self-directed investors, spending the time to sift through small caps to find a diamond in the rough can prove to be time well spent. Even in our data-rich world, great small-cap investments fly under investors' radars because they get little coverage from analysts.

Small-Cap Stocks and the Russell 2000

The Russell 2000 is a small-cap stock market index composed of the 2000 smallest companies in the Russell 3000. The index is frequently used as a benchmark for measuring the performance of small-cap stock mutual funds.

The S&P and Dow Jones indices focus on large-cap stocks.

Thus, investors hoping to track small-cap stocks' performance should keep their eyes glued to the Russell 2000 or the S&P 600—a similar small-cap index.

Are Small-Cap Stocks a Good Investment?

Small-cap stocks can be a good investment. They typically have the potential for growth, much larger than large-cap stocks/blue chip companies, so if an investor gets in at a good price, they may see a good return. Small-cap stocks are more risky and volatile than the stocks of larger, more established companies, so investors must take extra care in their analysis before making any investment decisions.

Which Is Better, Small-Cap or Mid-Cap?

Whether small-cap stocks or mid-cap stocks are better depends on the specific company. Any company with good fundamentals, a strong business strategy, smart leadership, and a competitive edge, can be a good investment, whether they are a small- or mid-sized company. Small-cap stocks have more growth potential than mid-cap stocks, so investors may see a better return; however, small-cap stocks are also more risky and volatile than mid-cap stocks, so the loss potential is greater.

Is Small-Cap Good for the Long Term?

Yes, small-cap stocks can be good for the long term. If you can invest in a small-cap stock that has good fundamentals and overall healthy analysis, the stock will most likely grow over the long term. If you can invest before a bull run on the market and hold the stock for the long term, then you could see a strong financial return.

The Bottom Line

Small-cap stocks are the stocks of companies whose market capitalization is roughly between $300 million and $2 billion. These companies are attractive investment opportunities for investors as they have the potential for significant growth with the possibility of becoming large-cap stock companies.

Because there is more upside than a large-cap stock, investors do take on more risk; but on the bright side, small-cap stocks have historically performed better than large-cap stocks. Investors should carefully evaluate companies with a smaller market cap to determine if there is growth potential before making any investment decision in the hopes of a future windfall.

Article Sources
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  1. Long Term Trends. "Large-Cap vs. Small-Cap Stocks."

  2. Library of Congress. "Investment Company Act of 1940."

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