Small-Cap Stocks

Some of the best investment stories of the past 25 years started with investors who recognized the potential of a small-cap stock. Just think of being an early investor in a company like Amazon (NASDAQ:AMZN), which was a $7 stock in 1998, or Tesla (NASDAQ:TSLA), which had a market cap of just over $1 billion in 2010.

Of course, not every small-cap stock becomes a giant. Investing in the stocks of small companies can be very rewarding, but it comes with risks that investors need to understand. Here’s a closer look at what small-cap stocks are, how to choose the best ones, and how to figure out if they’re right for you.

What are small-cap stocks?

Small-cap stocks are stocks of companies with a small market capitalization (the cap in small-cap). We say that a stock is a small-cap stock when the total value of all of the company’s shares outstanding -- meaning the shares held by all shareholders, including company insiders -- falls roughly between $300 million and $2 billion.

Small-cap companies are often young companies: They often have lots of growth potential, but they may also have less stability and market share than larger, established companies.

That’s exactly how it tends to play out with small-cap stocks. The risks may be higher versus larger-cap stocks, but the rewards may also be greater. (Note that the risks can be even greater with micro-cap stocks. Unless you’re a very experienced investor, it’s best to steer clear of stocks with market caps under $300 million.)

Since 2000, small-cap stocks have outperformed large-cap stocks over the long term by 2% per year. But the story is often different over shorter periods (think three to five years or so), because small-cap stocks tend to be more volatile than larger companies, with bigger ups and downs in their prices. Over longer periods, those ups and downs will seem to smooth out.

In 2020, for example, small-caps have vastly underperformed their large-cap counterparts. In the first half of the year, the small-cap Russell 2000 index lost 13.6%, while the large-cap-focused S&P 500 gave up only 4%. Large-cap companies are more likely to be profitable, have ample cash on their balance sheets, and have better access to capital, making them less risky in a crisis like the COVID-19 pandemic. Investors feel safer with large-cap stocks and many likely moved money out of small caps and into large caps during the pandemic. Of course, in a recovery you would expect small-cap stocks to outperform, as these stocks have greater growth potential.

Some top-notch small-cap stocks

Many small-cap stocks aren’t household names -- at least not yet. Here are some small caps to consider:

• Axos Financial (NYSE:AX) is an all-online financial services company. It provides things like auto loans and mortgages, financial advice, and brokerage services. Its all-online model helps keep its costs down and its rates competitive. Axos has struggled during the pandemic like most financial stocks, but its exclusively online presence should give it an advantage over the long term.
• Innovative Industrial Properties (NYSE:IIPR) is a real estate investment trust (a type of company that holds and profits from real estate investments) that buys and owns facilities that grow and process marijuana for markets where marijuana is now legal. Because marijuana is legal only in some states, companies entering the business often have a hard time getting financing. IIPR helps solve that problem by buying the facilities and leasing them back to the marijuana businesses. The stock has emerged as a relatively low-risk means of gaining exposure to the marijuana market, as it functions as a “picks-and-shovels” play on the fast-evolving industry.
• Yext (NYSE:YEXT) helps ensure that online information about companies like restaurants and hotels is up-to-date and accurate. Have you ever searched for a restaurant’s menu or location only to find that it’s outdated? Yext helps companies (like the Subway restaurant chain) make sure that customers looking online for information are getting up-to-date answers. This service has become even more valuable during the pandemic, as a number of businesses have been temporarily closed.

You can also get the benefits of small-cap stocks in your portfolio by investing in a fund that focuses exclusively on small caps:

• iShares Russell 2000 ETF (NYSEMKT:IWM) is anexchange-traded fund that tracks the performance of the Russell 2000 Index, the leading index of small-cap stocks.
• Fidelity Small Cap Growth Fund (NASDAQMUTFUND:FCPGX) is amutual fund that invests in small-cap stocks that have high growth potential. It’s actively managed, meaning that its manager works to beat the index’s performance. The fees are somewhat higher than an index fund’s, but the idea is that the improved performance covers those fees (and more) over time.

Related topics

How to evaluate a small-cap stock

The Motley Fool’s co-founder, David Gardner, believes that there are six signs of disruptive companies with high growth potential. He calls these kinds of stocks “Rule Breakers.” (For a deeper dive into this concept, check out David Gardner's Rule Breakers podcast.)

Top small-cap stocks often have the characteristics of disruptive companies:

• Leaders who are visionaries. Good leaders see an opportunity for something new and different, and can explain it as a compelling story.
• “First-mover” advantage, meaning that the company is first to (or a leader in) a new market. Alternatively, the company might have a deep “moat,” meaning that it’s hard for potential rivals to match what it’s doing.
• Competitive advantages that are clear to see.
• Good brands that customers love.
• A track record of rewarding investors. You want to see that the company’s management is taking care of the company’s owners, its shareholders.
• Detractors. Companies that fit this profile often have critics complaining that the company’s stock price is too high based on traditional ways of determining a stock’s value. Believe it or not, this is a good sign -- if the other characteristics are also present -- because it means that other investors are starting to see the company’s future growth potential, not just its current finances. Remember, for a stock to go up, we need others to see its potential and invest.

Usually a top small-cap stock will also have a history of earnings and revenue growth over time. If it doesn’t, we want to know why. Below, find details on each of these metrics.

Are small-cap stocks for you?

Can you hold an investment for several years? Are you comfortable with a stock that may have big price swings, both up and down? (Are you sure?)

If so, then small-cap stocks might have a place in your portfolio. As we’ve seen, small-cap stocks can add to your overall portfolio’s growth rate, as long as you have the time to smooth out the ups and downs. But remember that small companies have less room for error than larger, established companies, as was recently demonstrated again by the coronavirus pandemic. Therefore, it’s important to do your homework before investing in a small-cap stock.

Of course, you don’t have to pick individual stocks to get the benefits of small-cap stock investing in your portfolio. For many investors, owning a small-cap mutual fund or ETF as part of a diversified portfolio will be the best way to benefit from the potential of small-cap stocks.