How to Invest in Small-Cap Stocks

Small-cap investing focuses on companies that have smaller market caps than most stocks. Since these companies are worth less than large-cap or mid-cap stocks, they tend to be more volatile and carry more risks, but they also offer greater potential rewards. Read on to learn the pros and cons of small-cap stock investing, why you should consider small-cap stocks, and whether they're right for you.

Intro to small-cap investing

Intro to small-cap investing

Small-cap stocks are generally defined as stocks with a market cap between $300 million and $2 billion. This makes them worth less than the blue chip stocks that make up the Dow Jones Industrial Average and much of the S&P 500. The table below shows the categorization of stocks according to market capitalization.

Investors often consider investing in small-cap stocks because they tend to outperform in bull markets and can also represent hidden opportunities with greater upside potential.

By definition, small-cap stocks have a greater opportunity for growth than their large-cap partners, since the law of large numbers means it gets more difficult for companies to grow as they get bigger. It's much easier for a $1 billion company to become a $2 billion company, for example, than it is for a $1 trillion business to double its value to $2 trillion.

That's why the small-cap index Russell 2000 has typically outperformed the S&P 500 in bull markets. From 2001-19, investors in the iShares Russell 2000 ETF saw their money grow, including dividends, by 344%, while investors in the SPDR S&P 500 ETF have seen their money grow by just 253%.

The Russell 2000's higher average return might seem to suggest that investing in small-cap stocks is a sure-fire route to greater investment returns. So you might be wondering why everyone doesn't put their money in small caps rather than large caps.

Here's why: Russell 2000's returns come not only with a greater risk of loss but also with more volatility. The median, or exact midpoint of annual returns, is 11.8% for the S&P 500 ETF and only 9.8% for the Russell 2000 ETF. You'll notice that the Russell 2000 tends to outperform in bull markets but falls faster during bear markets.

The risk of greater losses and more volatile returns keeps many investors away from small-cap stocks. This is particularly true of investors who may need to withdraw their investment on a shorter time horizon, such as older investors who need to supplement their retirements. 

The Russell 2000 has also underperformed the S&P 500 in the artificial intelligence (AI) era because most of the gains from the AI boom have accrued to large-cap tech stocks like Nvidia (NVDA -7.03%) and the rest of the "Magnificent Seven." Meanwhile, high interest rates have put pressure on small-cap stocks.

If you're considering small-cap stocks, you should understand that the overall Russell 2000 index may overestimate returns and underestimate the risk associated with buying and selling individual small-cap stocks.

Since many small-cap stocks have little to no earnings or limited cash on their balance sheets, more of them file for bankruptcy than their larger peers. This is especially a risk during tough times because their balance sheets aren't as strong as those of larger companies, and they don't have the same access to lending. These factors have caused more bankruptcies than for larger companies, especially during bear markets.

Similarly, small-cap companies' diminutive size can mean that they are reliant on just one or two large customers, which can be a big risk if those companies falter.

On the other hand, successful small-cap stocks graduate to mid-cap or large-cap levels, and former small-caps like Amazon (AMZN -2.58%) have delivered returns of 100 times or more. 

What to look for

What should you look for when buying a small-cap stock?

While there are plenty of small-cap value and dividend stocks out there, the reason to buy small-cap stocks is their growth potential. Below are a few metrics to keep an eye on.

• Revenue growth: Sales growth is particularly important for small-cap stocks because younger companies should be able to deliver higher revenue growth than larger, more mature companies. If you're looking for a small-cap growth stock, revenue growth over 20% is ideal, as well as a track record of steady revenue growth. A deceleration in the top line can indicate that the business is either maturing or potentially failing.
• Earnings growth: Earnings growth is less important than revenue growth for small-cap stocks, but it's still worth considering. For mature companies, you'll want to see earnings growing at least as fast as revenue. Small-cap growth stocks may not have profits, but ideally, net income will be trending upward to narrow losses.
• Price-to-earnings (P/E) ratio: This metric is useful for determining if companies with earnings (remember, some companies have negative earnings) are relatively overvalued or undervalued. A lower ratio may indicate a company is a bargain, while a higher ratio may suggest it's too pricey.
• Price-to-sales (P/S) ratio: The P/S ratio is a company's market capitalization divided by its revenue, which can be a useful metric for companies that don't have earnings. Lower ratios generally reflect undervalued companies on a relative basis. However, price-to-sales ratios vary widely from industry to industry, so drawing apples-to-apples comparisons is particularly important. 

• Past price appreciation: The best-performing stocks tend to have a history of outperformance. They don't just take off after several years of trading sideways. So it's important to look for stocks that have a track record of growth, especially at the small-cap level, as this momentum can build for several years to come.
• Total addressable market (TAM): Since you're looking for small-cap stocks that can eventually become large-cap stocks, you'll want to consider the size of the opportunity the company is chasing. Is this company trying to disrupt a market worth tens of billions of dollars or even hundreds of billions, or does it have relatively little room for growth? A large TAM and high revenue growth can be an especially rewarding combination for a small-cap stock.
• Optionality: Optionality is the potential of companies to break into new business lines. Amazon's move into cloud computing is an example. It can be difficult to gauge optionality, but a look at a firm's operating history and industry should offer some hints.

Should you invest?

Is small-cap investing for you?

Compared to larger stocks, small-cap investing offers greater risks but also increased return potential. Investors should ask themselves about their risk tolerance and time horizon. Younger investors who plan to hold stocks for decades are generally better suited for small-cap investing than retirees living off dividend income.

Still, owning a few small-cap stocks is a good idea for most investors. If just one of these stocks takes off, it can transform your wealth or make up for dozens of bad picks.

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