Small-Cap Stocks

Updated: April 14, 2020, 1:28 p.m.

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 companies 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.

Category Market Capitalization
Micro-cap companies Less than $300 million
Small-cap companies $300 million to $2 billion
Mid-cap companies $2 billion to $10 billion
Large-cap companies $10 billion to $200 billion
Mega-cap companies More than $200 billion

Small-cap companies are often young companies. Think about what young companies are like: They often have lots of growth potential, but they may also have less stability than larger, more established companies.

That’s exactly how it tends to play out with small-cap stocks. The risks may be higher than with 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.)

Historically, since 2000, small-cap stocks have outperformed mid-cap and large-cap stocks over long periods by around 2% per year. But the story is often different over shorter periods (think 3-5 years or so), because small-cap stocks tend to be more volatile than the stocks of larger companies, with bigger ups and downs in their prices. Over longer periods of time, those ups and downs will seem to smooth out.

Tiny man with his big strong shadow behind him

Source: Getty Images

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, as well as financial advice and brokerage services. Its all-online model helps keep its costs down and its rates competitive.
  • 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 only legal in some states, companies entering the business often have a hard time getting financing. IIP helps solve that problem by buying the facilities and leasing them back to the marijuana businesses.
  • 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.

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 an exchange-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 a mutual 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 ETF’s, but the idea is that the improved performance more than pays for those fees over time.

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.)

We are living through an amazing time of technological growth, Rule Breaking, and opportunity for entrepreneurs and technologies that can do things better than they were once done.

David Gardner, cofounder, The Motley Fool

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. We 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 growth and revenue growth over time. If it doesn’t, we want to know why. Below, find details on each of these metrics.

Earnings growth

A stock’s price growth tends to follow the company’s earnings growth over time. It’s important to track the rate at which earnings have been growing when evaluating a stock. For companies that aren’t yet profitable, we want to see that losses are shrinking as sales grow. If losses are increasing, it’s important to look more closely to understand why before investing.

Revenue growth

Whether a company is profitable or not, we want to see that revenue is growing at a good pace. Revenue growth shows us that the company’s business is working; revenue growth that’s higher than what we see at more mature companies shows us that its business is working well.

On the other hand, if revenue is declining, that’s a warning sign: Look deeper, and don’t invest until you understand why.

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, more established companies. It’s extra 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.

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