According to Investopedia, a small-cap stock is a publicly-traded company that is currently trading between a market capitalization of $300 million and $2 billion.
The market cap is determined by multiplying the stock price of a company by the total number of outstanding shares.
This is the major difference between large-cap vs. small-cap stocks and why small-cap stocks generally fly under the radar.
Typically, when an investor is looking to purchase small-cap stocks, they do so with the expectation that their investment eventually turns into the blue chips of the future.
While this high-growth environment is quite exciting, it is often difficult to determine which stock will be the next Tesla (TSLA) because of the total number of companies that exist in this space.
Therefore, when learning how to invest in small-cap stocks, it is important to build an investment strategy that capitalizes on those stocks possessing excellent managers and focuses on providing real value to society.
This way you can be certain that your savings are in good hands, and that your investments are creating wealth for you and your family in the long run.
In this article, we breakdown:
- What is a small-cap stock
- Why you should invest in small-cap stocks
- How to invest in small-cap stocks
- Where to find small-cap stocks
- What to look for when investing in small-cap stocks
- The 3 best small-cap ETFs to buy
Should you invest in small-cap stocks
Now that we have set the foundation for what is a small-cap, let’s look at whether you should invest in small-cap stocks. Here is an explanation of why they are a valuable investment for any investor.
Warren Buffett once said:
“It’s a huge structural advantage not to have a lot of money. I think I could make you 50% a year on $1 million. No, I know I could. I guarantee that.”
For an individual who is often dubbed as one of the most humble human beings on Earth, the Oracle of Omaha sure created a buzz when making this boisterous statement.
But what if there is more to the story than what is being said on the surface?
Currently, Buffett is a long way from managing a measly $1 million as his colossal conglomerate Berkshire Hathaway (BRK-B) is now trading at a market value of $613 billion, and returning 20.1% annually since Buffett took over in 1965.
While this is definitely an admirable feat, it does not come without a few drawbacks of its own.
For instance, Berkshire Hathaway currently possesses around $106 billion in cash.
If Buffett was to buy an entire small-cap company at the highest market capitalization available ($2 billion), it would make up an insignificant 0.33% of Berkshire, at its current market value.
Since $2 billion is quite meaningless due to the overall size of the business, it is disadvantageous for Buffett to make such small investments because even a quick double would barely shake Berkshire’s balance sheet.
Instead, Buffett is forced to buy companies more similar in size, like his recent $51 billion purchase of Chevron (CVX) and Occidental (OXY), if he hopes to create meaningful returns for his shareholders.
But this is where we as retail investors have an advantage that even the legendary Warren Buffett envies.
Small-cap stocks are particularly advantageous due to the limited number of entrants able to invest in them.
While the small-cap market is less liquid than large-cap stocks, this typically isn’t a cause for concern unless you are investing with larger sums of money.
Since only small players are able to capture these wonderful returns, there is a massive upside to investing in small-cap stocks because they are generally younger businesses and have yet to reach their full potential.
By buying excellent small-cap stocks, in favorable industries, an investor creates a stock portfolio with uncontested growth and limited downside risk.
The catch is knowing what are the best small-cap stocks to invest in and how you find them.
For an alternative approach, venture capital is a style of “small cap” investing that has proven successful for the likes of Kevin O’Leary, a.k.a. Mr. Wonderful.
If you’re interested, check out our Venture Capital article to learn more.
Ways to invest in small-cap stocks
Small-cap stocks are often publicly traded on the same stock exchanges as large-cap stocks; these include the New York Stock Exchange, Toronto Stock Exchange, Nasdaq, etc; before going public, most companies raise capital through crowdfunding or private placements.
While these major exchanges are where you will find most stocks in general, there are other smaller exchanges like the Neo exchange, CSE, TSX.V, or Over the Counter exchanges (OTC) that trade small-cap stocks as well.
When looking into ways to invest in small-cap stocks, it is important to make note of what exchange they trade on and whether your online investment brokerage (ie. Questrade, Wealthsimple, Interactive Brokers, etc.) allows trading from that exchange.
Fortunately, most online investment brokerages allow trades on the major stock exchanges, however, you may have difficulty accessing certain small-cap stocks on smaller exchanges if the broker does not have access to them.
Each brokerage is different, so before setting up an account, ensure that your brokerage account is capable of trading the desired stock.
Where to find small-cap stocks
What is a small-cap index fund?
Small-cap index funds, like the Russell 2000 index, are excellent places to begin your search for stocks.
A small-cap index refers to a collection of small-cap stocks whose performance is tracked in real-time.
In general, indexes are meant to provide a well-diversified and unbiased reflection of the current economic state in a given market.
For example, the S&P 500 index is typically used as the benchmark index because it contains the 500 largest publicly-traded companies in the United States; although private companies are not included, the state of the S&P 500 is a solid indicator of America’s economic health.
Depending on the index, a set criterion is created to determine which stocks are included in the index and which ones are left out.
For the Russell 2000, the index is composed of 2000 small to mid-cap companies, mostly from the U.S, according to Investopedia.
By scrolling through the small-cap stocks listed on FKnol.com, you will find many that fit the “small-cap criteria”, meaning that they have a market cap between $300 million & $2 billion; currently stocks 450 to 1750 (ranked by market cap) fall within the small-cap range.
Here are a few other small-cap indexes that are worth looking into:
- What is the MSCI Small-Cap Index: it is a global small-cap index-tracking 4,493 small-cap companies
- What is the S&P/TSX Small-Cap Index: it is a Canadian small-cap index tracking 230 small-cap companies
- What is the S&P 600 Small-Cap Index: it is an American small-cap index tracking 600 small-cap companies
- What is the CSE Composite Index: with approximately 75% coverage of all equities listed on the CSE it is a uniquely positioned gauge of the Canadian small-cap market.
- What is the TSX Venture Exchange Index: contains small-cap Canadian stocks with over 1,600 companies listed.
Small-Cap Stock Screeners
Another, and often more effective way to find small-cap stocks is to use a stock screener that quickly sifts through any undesirable stocks.
While there are many stock screening tools available, Macrotrends.com’s stock screener is an excellent platform that is simple and free to use.
When using the screener, you can set the maximum market cap, filter through industries and sectors, as well as many other features.
Since there are nearly 4000 small-cap stocks to choose from on the platform, there are additional screening constraints Edge Investments uses in particular, to scan the crowd and find diamonds in the rough.
To find the best small-cap stocks, use the constraints:
1. Set the Market Cap Max to $1B:
Macrotrends.com does not have a $2B market cap max, therefore one should use this constraint if they wish to discover what is a small-cap stock.
2. Set the PS Ratio Max to 2:
The PS Ratio measures the price of a stock relative to the company’s revenue per share (RPS) in that year. Historically, stocks on the S&P 500 have an average PS Ratio of 1.66, therefore anything less than that implies that the business is trading on sale.
3. Set the LT Debt/ Equity Max to 0.2:
The LT Debt to Equity ratio measures the relationship between a company’s debt financing in relation to equity (shareholder stock) financing. Often businesses with a lot of debt have difficulty surviving during poor economic conditions, therefore a business that does not rely on leverage is better positioned for the long run.
4. Set the Min. Sales Chg 5Y to 200.0
The Sales Change 5Y measures the company’s ability to grow its revenues effectively over five years. As consistent financial growth demonstrates a healthy business, a 200% change in that period implies an annual growth rate of 25%.
Once you have set these constraints, your screen should look something like this:
As you can see in the top left corner, the original 4000 small-cap stocks have now been filtered down to just 60; note that all of the stocks present are listed in the United States.
While using the screening tool has effectively narrowed down your search to finding excellent small-cap stocks, it is still important for investors to evaluate each stock individually.
When looking at an individual small-cap stock, consider the company’s revenue, earnings, operating margins, shareholder equity, long-term debt, and free cash flow.
Furthermore, for each of these financial metrics, you should determine whether they are growing, shrinking, or stagnating year over year; the best businesses can grow all of them consistently while reducing their debt.
Additionally, when looking at small-cap stocks, one should consider whether a business is capable of operating and growing on its own, without additional financing, and how likely is it for them to go bankrupt.
Please note that this screening tool only evaluates the financial performance of a small-cap stock.
To understand what is a small-cap stock completely, there are other criteria you should incorporate into your investment analysis as well.
We will dive into these now.
What to look for when investing in small-cap stocks
Small-cap stocks exist in every market, industry, and sector.
With so many to choose from, knowing how to sort through the fluff is an important quality for every investor if they want to be successful.
Therefore, establishing investment criteria that extend beyond a company’s financial strength allows one to capitalize on small-cap opportunities other investors might be overlooking.
Often in the small-cap market, businesses are quite young in their industry, thus they might not have earnings at all, but that doesn’t necessarily mean it is a bad investment.
A lot of the time, businesses in their early-stage reinvest all of their available capital to maximize growth and establish themselves as a major player in their market.
What is more important, is the management in place and whether the business itself possesses a competitive advantage unattainable by its industry peers.
As such, here are some qualitative investment criteria suggestions that will help you determine the value of a business and its management.
For more context, check out our recent newsletter on small-cap oil stocks.
What is a small-cap stock’s story?
When evaluating a potential small-cap stock, the first thing you should consider is how well do you understand the business.
Immediately after learning about the stock, you should feel that the company’s story clicks and that the consumer need they are attempting to fulfill makes sense.
Furthermore, it should be clear to you what value they are adding to society and how capable they are of scaling their business into the future.
A simple way for you to gauge your understanding of a business is to reflect on personal experiences in that market whether it be as an employee, customer, or industry expert.
It is much easier to stomach a stock falling 20% if you know that the business is doing well and that it will continue to operate well into the future, regardless of how the market behaves; this is easiest in favorable industry environments where production and growth are expected to endure in the long run.
As renowned investor Peter Lynch would say:
“know what you own, and know why you own it.”
If you’re curious to learn more about Mr. Lynch’s investment strategy, check out our article on how he categorizes stocks.
Who is the small-cap stock’s management?
Your second consideration when evaluating a small-cap stock is the managers in place that are running the business.
A good manager, or CEO, is someone who is both a smart capital allocator and an effective leader that embraces their role with integrity, transparency, and accountability.
While most of us will not have the opportunity to speak with these leaders directly, there are alternative ways to evaluate how successful management will be.
First off, one should look into management’s track record, whether that be with the company they are currently running, or based on previous performances with other businesses.
It should be clear that management has demonstrated success in the past and that this is being reflected in the growth of the business; one metric to determine how effective they are running the business is the company’s return on investment capital (ROIC) which measures how much income they generate for every dollar invested.
Secondly, one should look at a management’s compensation structure and whether this is based on the performance of the stock or the actual business; a good compensation structure should reward managers for growing the company, not increasing the price of the stock.
Furthermore, it is beneficial for shareholders to have a management and board of directors that has a large portion of their net worth tied to the business; managers with money on the line if the business struggles, are incentivized to make sound decisions when leading the company.
Lastly, it is important to pay attention to what the managers are doing with their shares of the company; while stock purchases are a positive indicator, it is when managers choose to sell stock that investors should be wary.
Ultimately, it is quite difficult to know the true intentions of a manager, but if the majority of their actions are aligned with shareholders, then this is a promising sign for the small-cap stock.
The best managers will be honest with their investors and accountable when making mistakes.
For a small-cap stock with an excellent management team, check out our recent newsletter.
Three Small-Cap ETFs to buy in 2022
What is a small-cap ETF?
It is for investors who want to participate in the small-cap market but do not want to actively pick stocks or does not have the time to analyze them, exchange-traded funds (ETFs) are an excellent alternative that offers broad diversification into a variety of markets.
In its essence, an ETF is a basket of stocks that track an underlying index such as the Russell 2000.
Here are three small-cap ETFs that offer an excellent opportunity to invest in the small-cap space:
1. Vanguard Small-Cap Value ETF (VBR)
- Total Assets: $22.31 billion
- YTD Performance: -14.90%
- Overview: VBR replicates a value-stock benchmark that offers exposure to small-cap stocks that exhibit value characteristics in the U.S. equity market.
2. iShares Russell 2000 Growth ETF (IWO)
- Total Assets: $9.09 billion
- YTD Performance: -28.80%
- Overview: IWO replicates the Russell 2000 benchmark and offers exposure to small-cap stocks exhibiting growth characteristics in the U.S. equity market.
3. Vanguard S&P Small-Cap 600 ETF (VIOO)
- Total Assets: $1.64 billion
- YTD Performance: -18.64%
- Overview: VIOO replicates the S&P 600 benchmark and offers exposure to small-cap stocks in the U.S. equity market.