Why You Want to Invest in Small-Cap Stocks

posted on 06-07-2019
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.