Small-cap stocks: what they are and why you should care

Small-cap stocks vs. large-cap stocks

The main difference between small-cap and large-cap stocks lies in their market capitalization. Small-cap stocks have a market cap between $250 million and $2 billion, while large-cap stocks are valued at $10 billion or more. These differences in size affect how they perform, their volatility, and what type of investors are drawn to them.

Let's look at those differences in more detail:

Growth potential

Small-cap stocks tend to offer more growth opportunities than large-cap stocks because they represent companies that are still in their early stages. Large-cap companies, like Apple or Coca-Cola, are typically well-established, with usually more stable but slower growth.

Small-caps, on the other hand, may rapidly grow into large-cap companies if they successfully execute their business strategies.

Volatility and risk

While small-caps have more room for growth, they also experience higher volatility. Economic shifts or market downturns can have a more significant impact on small-cap companies due to their limited resources and exposure to risk. Large-cap stocks, by comparison, are more likely to tackle economic difficulties because of their financial strength and established presence.

Investor appeal

Small-cap stocks generally attract investors looking for high-growth opportunities, while large-cap stocks appeal to more conservative investors seeking stability and dividends. Large-caps are typically favoured by institutional investors, while individual or more risk-tolerant investors might prefer small-cap stocks for the potential for higher returns.

Market visibility

Large-cap stocks enjoy wide analyst coverage and institutional interest, giving them more visibility and often greater price stability. Small-cap stocks, on the other hand, may fly under the radar with less coverage, but this lack of attention can provide opportunities for investors to identify undervalued companies before they gain widespread recognition.

The benefits of investing in small-cap stocks

Small-cap stocks may not have the same level of attention as large-cap companies, but they provide investors with distinct advantages. Let's explore them:

Higher growth potential

Small-cap stocks represent younger or growing companies with room for expansion. This growth potential allows investors to capitalise on future earnings as these companies develop. While large-cap stocks may already be fully established, small-cap stocks have the potential to double or even triple in value if their growth trajectory is successful.

Access to innovation

Small-cap companies often operate in emerging industries or niche markets. These companies tend to be more innovative and agile, adapting quickly to new technologies or market trends. For investors interested in cutting-edge industries—like biotech, fintech, or renewable energy—small-cap stocks offer a chance to be early movers in high-potential sectors.

Undervalued opportunities

Due to limited analyst coverage and fewer institutional investors, small-cap stocks may be less efficiently priced. This provides an opportunity for savvy investors to identify undervalued stocks that could grow significantly once the broader market recognises their potential.

Diversification benefits

Adding small-cap stocks to your portfolio improves diversification. Since small-caps often operate in different sectors than large-cap companies, they provide exposure to industries that may be under-represented in traditional portfolios. Additionally, the performance of small-cap stocks is less correlated with large-cap stocks, which can help reduce overall portfolio risk.

Historical outperformance during recovery periods

As already mentioned, small-cap stocks have a history of outperforming large-caps during economic recovery phases. Their agility and ability to capitalise on new growth opportunities allow them to quickly bounce back in a recovering economy.

The risks of investing in small-cap stocks

While small-cap stocks offer significant growth potential, they also come with risks that investors should be aware of.

Here are the main risks associated with investing in small-cap companies:

Higher volatility

Small-cap stocks are generally more volatile than large-cap stocks. Due to their size and limited resources, small-cap companies are more susceptible to market fluctuations and economic downturns. This increased volatility can result in sharp price swings, making them a riskier investment for those who prefer stability.

Limited liquidity

Small-cap stocks tend to have lower trading volumes compared to large-cap stocks. This limited liquidity can make it difficult for investors to buy or sell a considerable amount of shares without significantly affecting the stock's price. In times of market stress, this lack of liquidity can increase price volatility further and hinder investors' ability to exit positions quickly.

Less access to capital

Small-cap companies often have less access to financing compared to their larger counterparts. During economic downturns or periods of tight credit, small-cap companies may struggle to secure the capital needed for expansion or even day-to-day operations. This can result in slower growth or, in extreme cases, financial distress.

Limited analyst coverage

Small-cap stocks receive less attention from financial analysts than large-cap stocks. This limited coverage can make it harder for investors to obtain reliable information about the company's performance, making due diligence more challenging.

Without extensive coverage, investors must rely on their own research, which can increase the risk of misjudging a company's value or growth potential.

Greater risk of failure

Small-cap companies are often in the earlier stages of growth, meaning they are more prone to business failure. The lack of a proven track record, combined with limited resources and higher operational risks, can lead to company bankruptcies or poor performance. This makes small-cap stocks inherently riskier, as investors could potentially lose their entire investment.

Small-cap stock indexes

Investing in small-cap stocks can be daunting due to their volatility and the challenges of selecting individual companies. However, investors can mitigate some of these risks by diversifying their portfolios through small-cap stock indexes. These indexes track a basket of small-cap stocks and provide broad exposure to this segment of the market.

Here are some examples of major small-cap stock indexes from both the US and globally:

Russell 2000 Index (US)

The Russell 2000 is one of the most widely tracked benchmarks for US small-cap stocks. It includes 2,000 of the smallest companies in the Russell 3000 Index. This index spans various sectors, offering diverse exposure to small-cap companies. It is frequently used by US-focused mutual funds and ETFs to provide investors with access to the small-cap market.

S&P SmallCap 600 Index (US)

Another prominent US small-cap index, the S&P 600, tracks 600 smaller companies but requires positive earnings for inclusion. This ensures that the companies in this index meet certain quality and profitability criteria, making it potentially more stable than other small-cap benchmarks.

FTSE SmallCap Index (UK)

The FTSE SmallCap Index is a key benchmark for small-cap stocks listed on the London Stock Exchange. It includes companies that fall below the FTSE 250 in terms of market capitalisation, offering investors exposure to smaller companies in the UK market. The index is commonly used by UK-based funds seeking small-cap exposure.

MSCI World Small Cap Index (Global)

For investors seeking global diversification, the MSCI World Small Cap Index includes small-cap stocks from 23 developed markets worldwide. This index offers exposure to companies in North America, Europe, and Asia-Pacific, making it a comprehensive option for global small-cap investing.

STOXX Europe Small 200 Index (Europe)

This index tracks the 200 smallest companies within the STOXX Europe 600, providing exposure to European small-cap stocks. It offers a broad representation of small-cap firms across multiple sectors in European countries, appealing to investors looking for growth opportunities within the European market.

Conclusion: The role of small-cap stocks in your portfolio

Small-cap stocks hold significant growth potential, making them a compelling option for investors willing to accept higher risks. These companies, often operating in niche industries, may present opportunities to benefit from early-stage growth that larger companies may no longer experience.

Moreover, diversifying through small-cap stock indexes, such as the Russell 2000 or MSCI World Small Cap Index, can potentially reduce individual stock risk while still tapping into the potential of this market segment.

The key is approaching small-cap investing with careful research and a clear understanding of the risks involved, including volatility and liquidity limitations.