Stock investing is a fantastic way to generate passive income without having to lift a finger.
Sometimes, it may even catapult you into a new financial position altogether.
But owning stocks is only one piece of the story.
To truly be a successful investor, you must know what stocks to invest in and when to buy them.
No, this does not mean timing the market or buying the dip.
It means finding excellent businesses, trading at a discount, and striving to hold them forever.
One intelligent way to do this effectively is in small-cap stocks.
With better growth potential and improved ownership opportunities, small-cap stocks could be the difference between you retiring at 35 years old instead of at 60.
In this article, we explain why every retail investor should invest in small-cap stocks and how to find wonderful stocks to invest in.
What is a Small Cap Stock?
Small-cap stocks are defined as publicly traded companies with a market capitalization between $300 million to $2 billion.
Though not always the case, small caps are typically younger companies with fewer years under their belt, which often means that they receive less exposure than larger companies like blue chips.
For this reason, retail investors are often tempted by their incredible growth potential, given that most of these businesses are still in their early stages and have ample room to grow in the future.
Furthermore, because they tend to fly under the radar, small caps provide smaller investors like us an opportunity to buy in before any big institutional investors, such as mutual funds or hedge funds, realize their value.
But these growth stocks also come with their own set of unique risks.
In general, small-cap stocks often trade less than larger companies which may lead to a lack of liquidity if there aren’t enough buyers and sellers in the market.
Also, due to their size, these businesses are typically more vulnerable to market downturns given that they have smaller economies of scale and their competitive advantage is certain.
That being said, many of these risks are inherent to an individual business and less so to the asset class as a whole.
We intend to touch on this more later in the article, but for now, let’s explore the reasons why you should consider adding small-cap stocks to your portfolio.
Opportunities Presented by Small-Cap Investing
In this section, we break down the many valuable possibilities that exist when investing in small-cap stocks.
Since every business is distinctly different from another, it is important to distinguish that not all of these advantages will apply to every small cap you come across.
In order to find small-cap companies that reap the most lucrative returns, an investor is required to devote serious attention to the fundamentals of a business while also taking into account the price point they intend to purchase the stock.
Fortunately, there are multiple ways to take advantage of small-cap stocks regardless of your skills or experience.
Advantages of Small Cap Investing: High Growth Potential
As mentioned before, certain small-cap stocks offer incredible high-growth opportunities for investors.
Because of their size in relation to large-cap stocks, many small-cap companies still have plenty of room to grow before the business matures and its returns begin to normalize.
Furthermore, since small caps tend to be in the growth stage of the business cycle, these companies usually prefer to reinvest all of their earnings instead of paying a dividend, which also leads to greater returns over the long run.
Over the past 30 years, small-cap stocks have outperformed large-cap stocks by 94%, according to Longtermtrends.
For example, if you invested $10,000 back in 1992, your investment would be worth $159,433 versus $150,810 if you invested in large caps instead.
Though this is impressive on its own, it is valuable to note that the Wilshire Small-Cap Index tracks more than 1,800 small-cap stocks.
If you were to eliminate all of the financially weak businesses from the index and focus solely on the businesses with the greatest fundamental strength, your investment returns would likely be even greater than those mentioned above.
All-in-all, small-cap companies are a great way to expose yourself to better gains, as long as you are comfortable with differentiating between good and bad businesses.
Advantages of Small Cap Investing: More Investment Opportunities
One of the best advantages to investing in small-cap companies as a retail investor is that you can buy in before the whales show up.
Primarily due to the size of the business, small caps are often disadvantageous for institutional funds because their returns would be insignificant compared to the hundreds of billions of dollars they are managing.
As such, this creates a wonderful opportunity for smaller investors to find more meaningful investments whereby they can significantly increase their ownership stake before the stock pops up on a hedge fund’s radar.
Another way of thinking about it is like this:
Apple is the largest publicly traded company with a market capitalization of $2.044 trillion.
If you were to invest in them as a retail investor, it would take another $2 trillion for the company to double once, meaning that a mature business like Apple would be required to improve its current business and value offering two-fold (which seems unlikely).
However, if you invested in a solid $2 billion small-cap business instead, you could easily double $2 billion multiple times before larger investors swoop in and buy the stock or the business matures.
By investing in small-cap stocks, not only do you get more bang for your buck, but you also have greater optionality as an investor, meaning that there is more potential to strike gold.
Ultimately, every investor’s success depends on the stocks they buy and the price they pay.
Therefore, because you have more stocks at your disposal, it is necessary to evaluate every business and only invest in those that are likely to generate the most value for your portfolio.
Advantages of Small Cap Investing: Diversification
Like with the first advantage mentioned above, small-cap stocks are a great way to diversify your portfolio because you’ll gain exposure to the up-and-coming businesses of tomorrow.
While you may prefer that the bulk of your portfolio is comprised of stable stocks, like blue chips, small caps offer you the ability to seek higher-yielding returns without sacrificing the long-term security you desire.
If you are wondering what the optimal level of diversification into small caps is, it is difficult to answer that question on a general basis because everyone’s investment goals and risk tolerance are different, meaning that there is no perfect answer.
Instead, consider your investment horizon, quality of life, family status, and other factors like these before making an investment decision.
Then, allocate a portion of your portfolio into small caps that achieve your investment goals without jeopardizing your livelihood or mental well-being.
If you prefer not to invest in individual stocks but want to expose yourself to the small-cap market, small-cap index funds or small-cap ETFs are an excellent choice.
For those wondering, here are a few of the best small-cap ETFs available in the market today:
- Vanguard Small Cap Value ETF ($VBR)
- Vanguard Small Cap Growth ETF ($VBK)
- iShares Russell 2000 ETF ($IWO)
Advantages of Small Cap Investing: Investing in the Future
We briefly touched on this early, but essentially most small-cap stocks are young businesses, meaning that they still have a lot of opportunities to grow before they mature and reach their full potential.
If you ever wanted to invest in the next Tesla, TikTok, or Google, this is the best place to start.
Think of a few industries that are currently trending and making waves in the stock market.
Are any of these industries of particular interest to you?
If so, it may be worthwhile exploring small-cap stocks in that sector because they could be one business that changes the world.
Every business has to start somewhere, and usually the small-cap market is a great place to look before it is already too late!
Advantages of Small Cap Investing: Greater Flexibility
The last major advantage of small-cap businesses is their flexibility.
As smaller companies, small caps are more nimble than mid-cap stocks or large caps because their businesses are less ingrained in the market.
Therefore, small caps are more likely to adapt to market changes and can even penetrate niche markets more effectively if it is valuable to do so.
A great example of this is AST SpaceMobile ($ASTS).
This small-cap company is building a space-based cellular broadband network using satellites and an extensive IP and patent portfolio.
Since they are a young company, can easily pursue this new market opportunity without receiving any pushback from customers or cannibalizing its other products, given that its is its main product.
However, unlike AST SpaceMobile, if Verizon or AT&T attempted to transition into this market right away, it would be harmful to their current business model because the new system would eat away at revenues made on their existing infrastructure network.
For this reason, it will take time for these legacy tech businesses to penetrate this new and exciting market, meaning that this small-cap will have years before its biggest competition arrives.
Though this is only one example, many small businesses are experiencing similar opportunities in their respective markets and striving to take advantage.
Overall, if you are searching for stocks that are already capitalizing on the future, you will probably find it in a business just starting rather than in an established player.
Are Small Cap Stocks Risky?
As it is with most investment vehicles, small-cap stocks bear their own set of unique risks that could ultimately affect your chances of success.
Therefore, it is important to address some of these risks so that you can be better prepared for what is likely to happen along your investment journey.
Keep in mind that not all risks will affect small caps in the same way and that some businesses may be more susceptible to various threats than others.
If you are planning to invest in individual stocks, then it is important to pay attention to a company’s inherent risks, in addition to the general risks we mention here.
With that being said, here are three risks associated with small-cap stocks.
Small Cap Risks: Lack of Liquidity
For a stock to be traded, the transaction requires both a buyer, wanting to purchase the stock at a specific price, and a seller, seeking to sell it at a specific price; these people are called market makers.
Since small caps receive less exposure than large caps and mid-caps, they often have fewer market makers available, meaning that sometimes the price of a stock can swing from one side of the pendulum to the other.
For example, Tesla ($TSLA) has over 3.16 billion shares outstanding, and over 197.64 million of those shares trade, on average, every ten days.
On the other hand, Himax Technologies ($HIMX), a small-cap semiconductor company with a market cap of $1.11 billion, sees about 1.17 million of its 174 million shares outstanding traded every three months.
With fewer shares being traded daily, weekly, or even monthly, a small cap may experience greater volatility and price changes, especially if there is a big discrepancy between the number of buyers and sellers in a given market.
Furthermore, in the extreme event that there are only a few buyers available, the price of a small cap may plummet if a large group of investors all try to sell the stock at once.
While uncommon, an investor should always be aware of these possibilities and take the time to prepare for a liquidity crunch because it will happen, and you don’t want to be caught in a situation where you are overwhelmed or make a poor decision based on emotions.
For those wondering, the easiest way to counteract your emotions when investing is to invest in predictable companies that are in solid financial standing.
That way, you can be assured that your investments will come out of this circumstance unscathed and better off in the long run.
If anything, it may be a great time to buy more shares of the company when other investors are panicking.
Small Cap Risks: Smaller Economies of Scale
Given their size, small caps often have smaller economies of scale, meaning that they most likely do not have the same purchasing power or competitive advantages as larger competitors.
As such, it is sometimes difficult to maintain a dominant position in an industry if a larger player chooses to challenge their position directly in the marketplace.
With smaller economies of scale, a small-cap company may struggle to purchase sufficient assets to compete, meaning that they end up struggling to survive or are forced to adapt their business model to strengthen their position.
A good way of thinking about it is how Amazon was able to undercut small and local retailers by offering lower prices to customers than their competitors.
This was only possible because the company had built a massive supply chain network and possessed billions of dollars in capital, which allowed them to lower prices without hurting their bottom line.
After that, all they had to do was wait until these smaller businesses collapsed under the pressure of the price war, and then they could swoop in and eat up the remaining market share.
While this is only one example, it is always valuable to know who a small-cap stock’s biggest competitors are so that you are more aware of the risks that threaten the success of your business.
To overcome these threats, focus on small caps with an established competitive advantage and lots of cash available at their disposal.
That way, they will at least have a fighting chance.
Small Cap Risks: More Susceptible to Market Conditions
It is no secret that the stock market is getting slammed right now, with many of the world’s biggest stocks falling over 50%.
But if you thought it was rough for the large caps and blue chip companies, then it is likely twice as bad for smaller companies and their investors.
Due to their unpredictability, investors tend to sell their positions in small caps before they unload shares in large-cap stocks.
This is because most investors associate risk and stability with the size of a company, meaning that they choose to stick with the more “secure” bets during a time of crisis.
However, one thing to keep in mind is that the performance of the stock will always be indicative of its fundamental strength over the long run.
Therefore, even if a small cap falls 90% in a year, it is probable that its share price will recover in time, especially if the business is fundamentally growing, increasing its revenues, net income, and free cash flow every year.
As we’ve mentioned throughout the article, the defining riskiness of a business is not based on the size of the company but, instead, is based on the underlying financial health and competitive advantage that the business possesses.
In other words, a small-cap company can be a whole lot less risky than a large-cap business with mountains of debt and shrinking revenues.
It all depends on the business you buy and the price you pay for it.
Why Invest in Small Cap Stocks
As you can see, there are many advantages to investing in small-cap companies, but there are also risks.
To be a successful small-cap investor, you must be willing to take the time to learn how to differentiate a good business from a bad one and also learn how to appropriately price a company before buying it.
If you commit to these skills, you are likely to set yourself up for a world of wonderful opportunities in the future.
Though nothing is guaranteed, small caps are a fantastic way to maximize your gains while minimizing risk.
Not only that, but they are a great way to invest in the businesses of tomorrow before larger investors discover them.
All-in-all, small-cap stocks are a great investment alternative that every investor should consider exploring.
To learn more about how we invest in small caps, check out our article How to Find Small-Cap Stocks to Invest In.