Small-Cap Stocks

Some of the best stocks to buy in the past 25 years started as small-cap stocks. Amazon (NASDAQ:AMZN) was a $7 stock in 1998, and Tesla (NASDAQ:TSLA) had a market valuation of just over $1 billion in 2010.

Of course, not every small-cap company becomes a giant. Investing in small companies can be rewarding, but also comes with risks that investors need to understand. Here’s a close look at small-cap stocks, including our picks for some of the best.

What are small-cap stocks?

Small-cap is short for small market capitalization, which is equal to a company's share price times the number of shares outstanding. A company is classified as having a small market capitalization when that market cap falls between roughly $300 million and $2 billion.

Stocks classified by market capitalization are generally divided as follows:

Small-cap companies are often young companies. They tend to have significant growth potential, but also are generally less stable than their larger, more established peers.

A comparison of the Russell 2000 (RUSSELLINDICES:^RUT), a small-cap-focused index, and the large-cap-focused S&P 500 (SNPINDEX:^GSPC) since 2000 shows that small-cap stocks have handily outperformed large-cap companies. The chart below demonstrates demonstrates the difference:

Over short time periods, the prices of small-cap stocks tend to be more volatile than those of larger companies, and the stocks' values fluctuate more dramatically. The longer the evaluation period, the greater the likelihood that small-cap stocks outperform the large-caps

Best small-cap stocks

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

1. Carparts.com

Formerly known as U.S. Auto Parts, Carparts.com (NASDAQ:PRTS) is an online auto parts retailer that has been transformed under new management. By consolidating its web brands under only the Carparts.com banner, the company has streamlined its business, and sales surged during the pandemic. The company is investing in technology and marketing, and just opened two new distribution centers. It also looks primed for continued growth, due to a semiconductor chip shortage in auto manufacturing that is boosting new and used car prices. Over the long term, the company is targeting 20%-25% revenue growth, meaning that Carparts.com is likely more than just a pandemic story.

2. ACM Research

As a manufacturer of cleaning equipment for semiconductor wafers, ACM Research (NASDAQ:ACMR) is a "picks-and-shovels" play in the semiconductor industry. Investing in ACM Research provides exposure to a high-growth industry without exposure to the risk of commodity chip prices declining.

Additionally, ACM is an American company that conducts most of its business in China, giving investors a relatively safe investing method for gaining exposure to the Chinese market. ACM is one of the rare small-cap companies that offers both high growth potential and solid profitability.

3. AppHarvest

One of the more intriguing small-cap stocks that recently began trading is AppHarvest (NASDAQ:APPH), a pioneer in vertical farming that went public in February, 2021, via a merger with a special purpose acquisition company (SPAC).

While AppHarvest is essentially a development-stage company, having earned just $2.3 million of revenue in the first quarter of 2021, the company aims to be the world’s largest indoor commercial farm. If its business model succeeds, then AppHarvest's market cap could increase by multiples of its current valuation, which is less than $2 billion.

Best small-cap funds

If you don't want to choose individual small-cap stocks for your portfolio, then you can instead gain exposure to small-cap companies by investing in a small-cap-focused exchange-traded fund (ETF) or mutual fund. Here are a couple of options:

• iShares Russell 2000 ETF (NYSEMKT:IWM): This ETF tracks the performance of the Russell 2000, which is considered the leading index of small-cap stocks. The fund's managers charge an annual management fee of 0.19%, which equates to $1.90 for every $1,000 invested.
• Fidelity Small Cap Growth Fund (NASDAQMUTFUND:FCPGX): This mutual fund invests in small-cap stocks that have high growth potentials. It's actively managed, with the objective of outperforming the Russell 2000, so the fund's fees -- 0.94% annually -- are somewhat high as compared with those of most ETFs.

Small-cap stocks after COVID-19

Market turbulence at the start of the pandemic caused small-cap stocks to lose greater value than their large-cap counterparts. But small-cap stock prices also recovered more quickly, and have actually outperformed the S&P 500 since the start of 2020, as indicated by the chart below:

While the prices for small-cap stocks can recover quickly from crises, small-cap companies typically struggle more in recessionary environments than large-cap companies. That’s because small companies are less likely to be profitable, have less cash on their balance sheets, and face greater difficulty with accessing external capital. All of these disadvantages make their stocks riskier investments in a crisis like a recession or the COVID-19 pandemic.

Today, the Russell 2000 trades at a significantly higher price-to-earnings ratio than the S&P 500, a reflection of the fact that small-cap companies tend to have lower profits but more growth potential than their large-cap peers.

Should you invest in small-cap stocks?

If you are willing to hold an investment for several years and feel comfortable with the price of a stock fluctuating greatly, then small-cap stocks might have a place in your portfolio. Owning small-cap stocks can boost your portfolio's overall growth rate, provided that you commit to a buy-and-hold investing strategy.

Remember, small companies are more likely to fail than large, established businesses, as was recently demonstrated during the coronavirus pandemic. It's important to conduct the necessary research before investing in any small-cap stock. You can also further lower your risk by investing in a small-cap-focused fund.