Investors generally treat small-cap stocks with some level of suspicion. In some ways, that suspicion may actually be earned.
They are notoriously more volatile and can be the first to take a serious downturn if markets start performing poorly. However, for savvy investors, they present an opportunity for superior performance.
What are small-cap stocks?
Small-cap stocks are identified by varying indicators in each market. In the US equity market, for example, small-cap stocks are defined as those in the bottom 10% of capitalization.
Why invest in small-cap stocks?
In short, small-cap stocks have a higher return on investment than large-cap stocks. The logic is sound enough. Consider a large corporation that lands a new, large business deal as opposed to a small-cap company.
While the deal may mean little to the total yearly revenue for a large company, it could be transformative for a smaller company. What would only present a 5% increase for a large corporation, could effectively double annual revenue for a small company.
When these events occur, the small-cap stock prices can explode, swiftly doubling in value or going far higher. So, while there are inherent risks in small-cap stocks, the potential rewards keep investors returning as they seek higher gains from their investments.
Even on a risk-adjusted basis, eInvest reports that over the last 20 years, small-cap stocks have consistently outperformed large-cap rivals.
How do you identify good small-cap stocks?
Small-cap stocks are often referred to as growth stocks because the businesses are still small and have plenty of room to grow and increase their performance. That doesn’t mean they will, though. While there is no guaranteeing how an individual stock will perform, there are some basic guidelines that can help target stocks likely to turn a profit.
Firstly, identify small-cap stocks and analyze their performances over a 52-week period. Then, target ones with a consistently good volume of trading. From those, you’ll want to identify stocks with a good 15% band of pricing.
That is, look for stocks that high and lows swing between 15% of valuation. Once you’ve built this shortlist, look for stocks that are currently on the low end of their 52-week valuation. Statistically, these will be the soundest investments.
All that being said, do consider the risks of small-cap stocks when determining how much to invest. While some of the dangers may be inflated, they are nevertheless real.
One thing to consider is further isolating your picks to small-cap stocks that have historically high dividend yields. This maximizes your chance of some return, even if the stock price underperforms.
Small-cap’s place in a broader portfolio
Large-cap equities have been trending for some time. With lower management costs and investors rarely outperforming the S&P index anyway, it seems to make financial sense to invest in equities. However, it should be noted that S&P itself reported that, in 2018, small-cap funds outperformed their respective benchmarks.
So, there is real money to be made, and small-cap investments can be much safer than they appear. The primary concern to remember is they are more sensitive to market changes.
If the market begins to perform poorly, small-cap stocks usually are the first to see their valuation hit hard. On the other hand, small-cap stocks have also shown historically that during a period of economic recovery, they can greatly outpace large-cap stocks in gaining in value.
While this is a mixed bag of advantages and disadvantages for small-cap stocks, the takeaway should be that investors should be more vigilant regarding large-scale changes in market health.
For better or worse, they have far more impact on small-cap stocks. Prudent investing with proper research can yield unrivaled returns through trading in small-cap companies.
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Luke Fitzpatrick is a freelance journalist and has been published in a variety of publications such as Forbes, Tech In Asia, and The Next Web. He is a guest lecturer at the University of Sydney, lecturing in Cross-Cultural Management and the Pre-MBA Program. Connect with him on LinkedIn.