It seems that a lot of new investors shy away from small-cap stocks because of their reputation. While this might be understandable at times because media outlets tend to emphasize the particularly negative aspects such as risk, lack of quality investors, and fraudulent activity. It is important to remember that, large-cap companies are not immune to these types of problems either. For a real-life example of this, look at a company such as Enron — which proved to be a perfect exemplar that large company size does not mean that investors cannot be scammed. Fortunately, though, there are some very positive aspects of investing in small cap companies too. This article will dive a little deeper into this topic to help you learn the different factors that you might want to consider before deciding if it is in your best interest to invest in small-cap companies.
The first step towards better understanding small-cap stocks is to define exactly what a small cap stock is. In the United States, “small-cap stock” refers to a stock with a market capitalization between $250 million and $2 billion. For reference, a mid-cap stock indicates that the market capitalization falls in the $2 – 10 billion range, while a large cap is greater than $10 billion. Furthermore, small-cap stocks can be traded on any exchange. However, most of them can be found on the Nasdaq or the OTCBB since they are more lenient about listing requirements. Lastly, before considering pros and cons, it is beneficial to understand the difference between small cap stocks and penny stocks. More specifically, the fact that it is possible for a stock to be small-cap but not a penny stock. Generally, this just means that the stock is trading for more than $1 per share — which often means better liquidity than most penny stocks. With this background information in mind, here are a few pros and cons of investing in small cap stocks:
Pro: Potential For Growth:
In most cases, even the largest companies you can think of were once small businesses. Moreover, small businesses can be great investment opportunities as they give low/mid net worth investors the opportunity to buy a relatively decent amount of equity – because of their low stock prices. For instance, if you were to have purchased 100 shares of Apple stock in 1980 you could have gotten it for around $0.50 per share (or $50 total). Today, 100 shares of Apple stock are worth roughly $18,000. Clearly, with a good amount of foresight and a little bit of luck, even a conservative investment into a small cap company can result in a significant profit down the road.
Con: Risk, There Is Always Risk:
In addition to the fact that many small businesses are run by less experienced professionals, tend to focus on new (sometimes unproven) ideas, and commonly struggle to consistently make a profit, they are also more susceptible to volatility. As a matter of fact, the reason for this is quite simple, since small-cap companies are “small” it takes less volume traded to move prices. For example, it is not uncommon for a small cap’s stock price to fluctuate 5% or more within a single day. Ultimately, this scares off some investors because the prices can change so much and, in almost all cases, the stocks have less liquidity than that of bigger companies. This means that investors might not be able to exit their position whenever they want, which is an aspect to take into consideration.
Pro: Under Recognition
Since they are so small, small caps often draw minimal analyst coverage or attention from Wall Street. As an individual investor, this is important because a stock that is underreported on has a higher likelihood of being improperly priced. Consequently, there could be an opportunity to profit from inefficiencies resulting from the lack of coverage devoted to a specific area of the market. Keep in mind this does not mean that all under reported stocks are good buys. However, if your goal is to eventually buy a “unicorn” stock at an early stage, the under recognition of smaller companies is something to pay attention to.
Like any investment, small cap stocks require investors to take on risk. However, as you now know, the amount of risk in this case can be considerably higher than what you are exposed to by investing in large caps and blue chips. That said, the future potential earnings are also much greater, so perhaps taking on more risk would be worth it? Ultimately, such a decision is something for you to decide for yourself. As always, do your due diligence and make the best possible financial decisions for you!