Small-caps stocks generally refer to shares of companies where market capitalization, or the value of all shares owned by all shareholders in the company amounts to less than $500 million dollars. This definition is not universal however, and in some cases companies with market capitalization of as high as $2 billion may be referred to as small cap stocks.
Although small cap stocks can belong to any industry, many small-cap companies are in new or high growth industries like technology, biotechnology and resources. These companies may lack stable revenue and earnings but generally promise superior growth prospects, and investors are drawn to invest in them in the search for potentially higher returns.
For example, in Canada, many small-cap companies are small mining and oil & gas companies. Often these companies are very early stage exploration and development companies without any production. Investors buy them based on the properties they own and on the chance that they will find a major deposit that will lead to future revenue and high earning growth.
In general, small cap stocks are riskier as an asset class, since many small companies fail to continue as viable businesses. However, if a small company does succeed, it generally results in very handsome rewards for the investors in the stock of that company. Investing in small cap stocks therefore is not for everyone. Such investments are more suitable for growth investors, who are willing to take more risk and have longer investment horizon.
Guide to Investing in Small Cap Stocks
Making investment in small cap stocks is an individual preference that is not suitable for every investor. When you are looking to invest in small cap stocks, remember that the potential to achieve very high returns is fraught sometimes with the danger of risking the entire investment amount. Although there are a number of positive factors associated with small cap investing, they weigh against some strong negative attributes.
Strong growth potential It is a fact that many successful big companies started very small and their stocks were small cap stocks during the early stages of their evolution. The stock market is abound with examples of companies such as Starbucks, Yahoo, Ebay and Wal-Mart, to name a few, which were small businesses and had small market capitalization in the beginning. Those individuals who invested in such companies at an early stage and remained invested reaped huge returns over time.
Because small caps are companies with small total values, they have the ability to grow in ways that are simply impossible for large companies. A large company, one with a market cap in the range of $5 billion to $10 billion doesn’t have the same potential to double in size as a company with a $200 million market cap. So if you are looking for high-growth companies, small caps are normally the answer.
Most small cap stocks belong to companies that are still at an early stage of development. These companies are normally more focused and devote their attention to a particular business area. It is easier to analyze such companies and properly evaluate their business prospects in the near future as opposed to bigger companies that can have complex operations.
Under the radar
Small cap stocks are generally neglected by research analysts and often undervalued by an uninformed market. This presents tremendous opportunities for individual investors who can profit from the inefficiencies caused by the lack of coverage devoted to a particular area of the market.
Small cap stocks are often associated with small and unproved businesses that have higher chances of failure. This leads to higher risk for investors. Small businesses often are narrowly focused with little or no diversification to protect against normal fluctuations in business cycles and hence more risk.
Small caps are also more susceptible to volatility, simply due to their size – it takes less volume to move prices. It’s common for a small cap to fluctuate 5% or more in a single trading day, something some investors simply cannot stomach.
Although, most small cap stocks are less complex to analyze compared to large cap stocks, it is hard to obtain even basic information on small cap stocks. For individual investors, it becomes hard work to obtain proper qualitative and quantitative information on small cap stocks to conduct adequate investment research. Financial ratios and growth rates are widely published for large companies, but not for small ones. Since there is hardly any analyst coverage on most small cap stocks, one must construct a well-informed opinion of the company with very limited information.