Many investors recommend investing in small cap stocks as these stocks allow investors plenty of room to make money but are not nearly as risky as investing in start-up companies.
Below, you will discover exactly what small caps are and some tips for investing in small cap stocks so you can make an educated decision when investing in small caps.
Small Cap Stocks – Definition and Broker Variances
Traditionally, small cap stocks are considered any stock with a market cap (or the value of the shares owned by shareholders) of 2 billion or more. This means that small cap companies are companies which have less than $2,000,000,000 of stock issued.
As you can see, the term “small cap” is a bit misleading as a billion-dollar company can be considered a small cap.
In fact, many brokerages will add 1-2 more divisions under small cap such as micro-caps or nano-caps which refer to companies worth under $100 million. You have to check with your broker as they may sort small caps by a different definition.
Regardless, small caps are not particularly small companies but rather are often successful companies which are looking to bring their company to the next level.
Given their size, small caps are not considered extremely risky (like penny stocks) but are not considered extremely safe either (like large caps). Like always, investing in stock has its risks and a small cap company is more likely to fold than a blue chip stock.
However, small caps also have much more potential for growth than a large cap. It is much easier for a company to grow their market cap from 1 billion to 10 billion then it is for a company to go from a market cap of 100B to 1000B.
As a result, most investors like to invest into both small and large caps, as large caps are seen as safer with steady returns whereas small caps can provide great returns should you pick the right company.
Investing in Small Cap Stocks – Doing Your Research
Investing in small cap stocks is different than investing in large cap stocks. When buying large caps, many investors like to take a “value” approach, where they try to find companies which have a market cap below their true value or buy into companies which pay a good dividend and offer steady, reliable growth.
When buying small caps on the other hand, most investors at looking at potential rather than current performance. For example, let’s look at Chipotle (CMG) when it launched back in 2006.
This particular small cap stayed around the same price point for a year due to investors looking at the balance sheets, but balance sheets do not always tell the entire story.
If you asked anyone about their Chipotle experience, nearly everyone would rave about how delicious their food was (save perhaps in California or Texas where burrito joints are a lot more common). If you went to a store at lunch time, the line would be out the door.
It doesn’t take a genius to figure out that with only about 500-600 locations at the time they went public, there was significantly more room for growth in the form of new restaurants. You don’t need a balance sheet to tell you that – you can experience it in real life.
At the time of this writing, CMG is up 650% from it’s market launch just 5 years ago and is no longer a small cap with its new market cap of around 10B.
The take-away lesson here is that small caps can grow off of a great business model or proprietary product whereas large caps typically cannot. It takes an incredibly successful product like the iPad for a large cap to grow at the rate a small cap stock can based on a single product or item.
When picking out small caps, you want to see how people respond to the business. Is this something that is going to catch on? Is this a good product or service? Oftentimes the best way to find out is in real life.
When you have to wait for an hour at a chain like CMG for lunch, then you know that the company can support more locations and is poised for a lot of growth.
Small Cap Stocks – The Bottom Line
At the end of the day, small cap stocks are a great way to invest in the stock market but are more risky than investing into large companies. Proprietary technologies and a strong business model can often propel small cap stocks towards massive growth.
On the other hand, relying so much on a single product makes the investment less stable. Choosing winning small caps often comes down to intuitively understanding what product or service has potential and what does not.
If you are just learning how to invest, there is no need to rush into buying small caps. You can always buy into much safer large cap stocks and only buy small cap stock when you find the right company at the right price.