Small-cap stock investing is an exciting adventure filled with wonderful opportunities to build wealth.
With over 1650 stocks to choose from in the major US exchanges alone, your options as an investor are essentially endless.
But knowing how to find small-cap stocks to invest in that are both worth your while and good investments is a completely different story.
That is why before investing, it is important to understand your objectives as an investor and to be aware of what to look for so that you can achieve your financial goals for the future.
In this article, we teach you:
- How to find small-cap stocks to invest in
- What is a small-cap stock?
- What to consider when thinking about how to find small-cap stocks to invest in
- And More!
What is a Small-Cap Stock?
A small-cap stock is commonly defined as a publicly traded company with a market capitalization trading between 300 million and 2 billion dollars, according to Investopedia.
In most instances, large-cap stocks (think blue chips) were once small-caps that eventually grew, either fundamentally or speculatively, into the giant corporations that we know today.
Regardless, all businesses start small, but there are a few cases where a small-cap stock is so exceptional that it creates immense value for society, and effectively grows enough to surpass the $2 billion market cap threshold.
Those are the businesses we want and the investments we intend to hold for the long run, possibly even forever.
But how can you tell the differences between a good small-cap investment and a bad one?
Well, first we should consider the pros and cons of small-cap stocks in general, then, we will narrow down our search to focus solely on the best small-caps in the business.
Why Invest in Small-Cap Companies?
There are many good reasons to include small-cap stocks in your investment portfolio if you intend to invest in individual stocks.
As a retail investor, being able to find opportunities where the return potential is greater than most other asset classes is huge because it allows you to achieve generational wealth faster without sacrificing your downside protection.
Here are two advantages to investing in small-cap stocks.
Advantages of Small-Cap Stocks #1: Massive Growth Potential
Given their size as a business, the best small-cap stocks have the opportunity to grow 100x or more depending on the type of business and the management in place.
Unlike large-cap stocks that already reached their potential and are now in their maturing stage as a business, many small-cap stocks have long runways ahead whereby their best years have yet to be realized.
To emphasize this point, consider a company like Apple (AAPL).
As the largest publicly traded company in the world trading at a market cap of $2.68 trillion, the likelihood of Apple doubling to a $5.36 trillion market cap is slim given that they would have to find new ways to create value, equal to everything else they already offer.
Whereas, if you invest in a small-cap company with strong business fundamentals, an intelligent management team, and trading well below what it is worth, then you as an investor now reap the benefits of jumping in on a great company early.
In the hypothetical situation that a small-cap business was to reach the same size as Apple Inc., your investment would double about 10.5 times, making a $10,000 investment worth $15.36 million.
Advantages of Small-Cap Stocks #2: Better Opportunities for Small Investors
As a retail investor, you have two major advantages over institutional investors, like hedge funds or wall street analysts, the first, being the ability to move money in and out of investments more quickly, and the second, being that there is a greater number of investment opportunities available to you in general.
Unlike you, large investors are forced to find investments that generate meaningful returns or face the consequences of dealing with unhappy investors.
To do so, they must focus on businesses with large market caps because smaller companies fail to provide adequate returns on their investment.
To illustrate this, think of a hedge fund managing $500 billion in assets.
If this hedge fund was to buy an entire small cap company worth a $2 billion market capitalization, this would make up a measly 0.40% of the portfolio.
Heck, even if they were to triple their investment in a year, the ROI would only be 0.80%.
As such, most large investors tend to stray away from small-cap stocks out of necessity even if the business piques their interest.
Fortunately, this isn’t the case for us little guys.
As a retail investor dealing with less than $100 million (as I expect most of us are), the stock market is your oyster.
With every investment vehicle available at your disposal, including small caps, the possibilities are endless because you can buy in before the big guy’s takeover.
This is hugely advantageous because early investments into the best businesses lead to the greatest returns in the long run.
Think of it like buying into the tech giants of tomorrow, today.
Are Small-Cap Stocks Risky?
Yes, certain elements of small-cap stock investing are inherently risky due to the size of the company and the number of active traders available in the market.
For more context, here is one risk to consider when investing in small-cap stocks.
A Small-cap Stock Risk: Unproven Track Records
In many cases, but certainly not all of them, small-cap stocks are younger companies with fewer years behind them.
As such, it tends to be more difficult to assess how they will perform, compared to older, more established businesses, because there is less financial information available about the company.
With a younger history as a business, there is greater uncertainty about how they will fair during poor economic conditions, especially if they have yet to be profitable.
To mitigate this, Edge Investments focuses on small-cap businesses that are profitable, growing, and have at least three years of publicly traded experience under their belts.
That way we eliminate most of the uncertainty and ensure that they are better positioned to succeed as a business in the future, regardless of the economic environment.
This also means that we avoid speculating on small-cap stocks that are promising fortunes but have yet to prove their ideas work.
As investors, our goal is to only invest in the best small-cap stocks because we must always protect our downside when seeking out high-returning investments.
Have you ever wondered whether it is better to invest in small-cap or large-cap stocks?
Check out our article “What is Small Cap vs. Large Cap?” to see which asset class is more worth your investment
How to Find Small-Cap Stocks to Invest In
Now that you have a better understanding of small-cap stocks in general, including the advantages and risks involved when investing in them, it is time to learn how to find small-cap stocks to invest in.
While there are certainly different methods for discovering small-cap stocks, we will focus on one strategy that delivers superior results because it sorts the diamonds from the rough by prioritizing fundamental strength over speculative hype.
That being said, we always recommend conducting additional research on an individual investment because the better you understand your investments, the more likely you are to succeed in the long run.
In this case, ignorance is not bliss.
It is our money after all, and we take every investment decision seriously.
How to Find Small-Cap Stocks to Invest In Step #1: Explore the Small Cap Indexes
The best place to begin your small-cap stock hunt is by looking into the many small-cap indexes available on the stock market today.
Small-cap indexes are excellent because they essentially eliminate the need to find small-cap stocks given that the criteria is already created for you.
Not to mention that the small-caps included in the indexes are more reputable because they must first meet the index’s unique requirements before being listed.
Here are a few of our favorite small-cap indexes:
How to Find Small-Cap Stocks to Invest In Step #2: Use a Screener
Screening tools are one of the most effective tools for investors wanting to learn how to find small-cap stocks because they quickly eliminate assets that fail to meet your requirements.
If you are uncertain about where to begin, start by setting a screening tool’s maximum market cap to $2 billion ($1 billion max on Macrotrends) and minimum market cap to $300 million.
That way, you gain access to all the available small-cap stocks in the database and can commence your hunt for the best small-caps of the bunch.
From there, you may want to explore small-cap companies in general, but if you desire a more strategic approach, it is recommended that you add additional criteria like a specific industry or two, a maximum P/E ratio, or a minimum ROE, and more.
Although there are plenty of screening tools available at a cost, and most online brokerages offer a screening tool of their own, there are a few excellent free stock market screening tools as well.
Here are the three best free stock market screeners:
Play around a bit and find out what investment criteria best suits your goals as an investor.
For more information on the criteria, we use, check out our article “What is a Small-Cap”.
How to Find Small-Cap Stocks to Invest In Step #3: Compare it to the Competition
Now that you found a few small-cap stocks of interest, the next step is to compare them with other businesses within the same industry.
Not only will find other small-cap companies available in that market, but you will also begin to understand where a small-cap stock might be headed if there are more established companies already within.
To find these comparable companies, use the screening tool to gather as many small-cap companies as possible within that industry.
In addition, expand your search by reading articles available online that discuss the industry itself or specific small-cap companies in the space.
An example of this would be the Top 5 Small-Cap 5G Stocks in 2022.
By exposing yourself to a variety of sources, you will acquire a balanced perspective on stocks in that industry and discover how many there are.
The next step is deciding which of the small-cap stocks is the best choice for your investment portfolio.
How to Find Small-Cap Stocks to Invest In Step #3: Picking the Winner
There are a lot of factors that come into play when investing in individual stocks, but one of the surest ways to find success is by investing in the companies you determine are the strongest financially, possess a sustainable competitive edge, and have a good management team in place.
Not only that, but you also want to purchase these small-cap businesses when they are trading at a discount so that you can realize superior returns, while also protecting your downside risk.
Ask yourself…
Does the small-cap stock have a competitive advantage?
When comparing small-cap stocks in a particular industry or market, an investor should look at metrics that indicate solid financial health.
These include a company’s Return on Equity (ROE), Debt to Operating Cash Cash Flow, Profit Margins, Revenue growth, and more.
By taking these numbers into account, an investor will see how they are fair in comparison to their competitors, meaning that you ultimately determine who is the leader of the pack, from an economic standpoint.
While this is a good start, it is important to understand how that money is being made and what the small-cap company is doing to improve its value offering even further.
How good is the small-cap’s management team?
In addition, one should look into whether a company’s management team is aligned with its shareholders.
To do so, determine how much management’s money is invested in the business and whether their decisions as managers are helping the company effectively grow.
Although most of us are unable to speak to these CEOs directly, you can find a company’s insider ownership on a website like Yahoo Finance and measure their skills as a manager through the company’s Return on Invested Capital ratio.
In doing so, you will gain a clearer picture of whether the company’s management team is in it for the money or for the long haul.
But it doesn’t stop there.
Is the small-cap stock trading at a discount?
The last, but certainly not the least important thing to consider is what the business is worth.
For those familiar with the Discounted Cash Flow model, this is an effective way to value a small cap company because you are directly forecasting the business’ operational growth while taking into account the risks involved with the company.
That being said, if you are unfamiliar, another great option is to compare a small-cap stock’s P/E, P/S, and P/BV ratios with other companies in the industry.
The general rule of thumb is whichever business possesses the lowest ratios, across the board, compared to the others, is considered the most undervalued relative to its peers.
So if you find a small-cap company that is the cheapest, by comparison, has a good management team in place and is the strongest financially, then that small cap is a strong buy because you are likely to strike gold with your investment.
As you will notice throughout your investing journey, you will find that these incredible opportunities are rare and difficult to find.
But if you stay patient and are ready to pounce when the opportunity presents itself, then your future as an investor should be filled with fortune and happiness.
Happy investing.