What Is Small Cap?

Small cap is a term used to classify companies with 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 US$300 million and $2 billion.

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Small Cap Stock

Advantages of Small-Cap Stocks

One of the most significant benefits 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. The fund would usually have to file with the SEC to overcome these limitations. When a fund does this, it 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.

Key Takeaways

  • A small cap is generally a company with a market capitalization of between $300 million and $2 billion.
  • The advantage of investing in small cap stocks is the opportunity to beat institutional investors.
  • Small cap stocks have historically outperformed large cap stocks.

To calculate a company's market capitalization, multiply its current share price by the number of outstanding shares (or the number of shares the company has issued to the market).

For example, as of January 2019, Shutterfly, Inc., has issued 32.98 million shares and had a current share price of $45.45. Following the formula, Shutterfly's market capitalization is approximately $1.46 billion. Most brokerages consider the company to be a small cap company.

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. A large cap offering has a market capitalization of $10 billion or higher. 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.

Small Cap vs. Midcap

Investors who want the best of both worlds might consider midcap 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.

However, for self-directed investors, spending the time to sift through small caps offerings to find that "diamond in the rough" can prove to be time well spent. That is because, even in our data-rich world, great small cap investments may fly under investor radar because of thin analyst coverage. With scant coverage important company news, developments, and innovations can go unnoticed. By contrast, news coming out of the large tech companies make instant headlines.

Real World Example

After the first six weeks of 2019, market prognosticators were predicting a big year for small-caps in 2019 as the small-cap Russell 2000 index had advanced 12.9%, versus a 9% gain for the benchmark S&P 500 index. Another small-cap index, the S&P 600, gained 12.1% during that time. The rebound came after a December 2018, which saw the Russell 2000 and the S&P 600 both dip 20% below their August peaks. Many investors—perhaps mistakenly—saw that as confirmation of a bear market. This development underscores the more unpredictable nature of small caps.