You may have been intrigued by stories of investors buying into Microsoft (Nasdaq: MSFT) in the early 1990s or Wal-Mart (NYSE: WMT) in the 1980s. Buying these companies when they were still small would have netted your investment millions. The good news is there are more stocks like Wal-Mart and Microsoft out there for the picking, in the form of small-cap stocks.

Definitions of what constitutes a small-cap stock vary, but the general rule is a stock with a market capitalization between $300 million and $2 billion. Stocks valued below $300 million are generally called micro-caps.

Small-caps can be listed on any stock exchange. However, most are found on the Nasdaq exchange or 'Over-the-Counter' (OTC) because of the less demanding requirements for listing on those exchanges compared to the New York Stock Exchange.

One reason people invest in small-cap stocks is simply the challenge and thrill for some investors to attempt to make a fortune by finding the next small company that grows into a giant.

However, there is more than thrill chasing behind the rationale. There are cold, hard facts. As a whole, small-cap stocks have outperformed their large-cap brethren on a long-term historical basis. According to Ibbotson Associates, an investment consulting firm that tracks long-term data, from 1927 to 2007 small-cap stocks increased in value by more than +12% per year while large-cap stocks increased by about +10% per year during the same period.

The outperformance of small-cap stocks versus large-cap stocks is even more impressive when looking at the period when the overall economy is coming out of a recession. The following data, which covers from 1945 to 2007, was compiled by Morningstar and Old Mutual and compares the performance of both large and small-caps when coming out of recession (starting at the recession's end):

After 6 months: Small-caps - +20.1% Large-caps - +11.4%
After 1 Year:
Small-caps - +33.7% Large-caps - +12.1%
After 3 Years: Small-caps - +74.0% Large-caps - +17.7%

Why You May Want to Invest in Small-Caps

There are several reasons for the outperformance of small-cap companies that make them attractive investments. First, smaller companies are more nimble and can grow faster than their larger counterparts. This ability enables a small company to seize opportunities (release new products, enter new markets, etc.) much more quickly and efficiently than large corporations.

And since most small-cap companies have little or no visibility in the institutional investment community, there is often a disconnect between their stock prices and the fundamentals of the company. This gives smaller investors a tremendous opportunity to take advantage and purchase rapidly growing companies that the institutional investor cannot.

Many small-cap companies also receive little or no coverage from the Wall Street analyst community. Therefore, with the lack of analyst coverage for most small-cap companies, the advantage goes to the smaller investor who can possibly uncover some new, exciting development about a company before it becomes known to the investing community at large. This lack of visibility for small-cap companies can again lead to a huge discrepancy between its stock price and its actual value, benefiting investors.

Why You May NOT Want to Invest in Small-Caps

But there are also some disadvantages to investing in small-caps. Many small-cap stocks are thinly traded, so there is sometimes a lack of liquidity. This may make it difficult to get in or out of a particular small-cap without disturbing the price.

The lack of trading volume can also lead to a large spread between the buying and selling prices, making it more difficult to enter a trade at an attractive price. In addition, pitfalls such as not being able to always obtain financing and a heavy reliance on the domestic economy can make small-caps more risky than established large-cap companies.
However, many investors believe that the rewards for investing in small-cap stocks and the potential for large gains far outweighs the risks involved, and the long-term performance of small-cap stocks supports that belief.

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Paul Tracy
Paul Tracy

Paul has been a respected figure in the financial markets for more than two decades. Prior to starting InvestingAnswers, Paul founded and managed one of the most influential investment research firms in America, with more than 3 million monthly readers.

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