What Is Small Cap?
The term small cap describes companies with a relatively small market capitalization. A company's market capitalization is the market value of its outstanding shares. The definition for small cap varies, but generally means a company with $300 million to $2 billion in market capitalization.
- 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 through growth opportunities.
- Small cap stocks have historically outperformed large cap stocks but have also been more volatile and riskier investments.
Small Cap Stock
Advantages of Small-Cap Stocks
One benefit 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 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.
Keep in mind that classifications such as large-cap or small-cap are approximations that change over time. Also, the definition of small cap stocks vs. large cap stocks can vary among brokers. 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, consider a company with 39.26 million shares outstanding and a share price of $45.50. Following the formula, it has a market capitalization of approximately $1.79 billion. Most brokerages would consider the company to be a small cap.
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 (GE) and Boeing (BA), the most aggressive growth tends to be in the rear-view mirror. 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 (MSFT), Cisco (CSCO) and AOL Time Warner. After the bubble burst in March 2000, small-cap companies became the better performers, as many of the large caps that had enjoyed immense success during the 1990s hemorrhaged value amid the crash.
Smaller than a small-cap is a micro-cap, a publicly-traded company in the United States that has a market capitalization between approximately $50 million and $300 million.
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 to find that diamond in the rough can prove to be time well spent. Even in our data-rich world, great small cap investments 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.
(For more on this topic, see: Small Cap Stocks vs. Large Cap Stocks: What's the Difference? and Are Small Cap Companies Riskier Investments Than Large Cap Companies?)
Real World Example
In the first six weeks of 2019, market prognosticators were predicting a big year for small-caps after 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 followed a terrible month for small caps, in which the Russell 2000 and the S&P 600 both dipped 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.