While everyone’s focusing on large-cap stocks thinking they’ll keep dominating, take a look a little further and you’ll find the underdogs that can take your portfolio to new heights by surprise. In fact, small-cap stocks can be better value if you know how to buy them.
But before describing why, let me define some terms for any new investors. Small-cap stocks are that of publicly traded companies with a market capitalization between $300 million and approximately $2 billion. They’re “small” because of the relatively small market capitalization, and alongside that, the fewer number of shares comprising these companies. Although you’ll typically find that small-cap stocks are pricey, they’re still a great option for individual investors. The reason is that when an individual buys stocks from a small-cap stock company, the purchase can represent a significant fraction of the company. When a significant percentage of a company is bought, it triggers SEC filing requirements, making that purchase public knowledge—in turn, increasing the stock price even more. So the first benefit of small-cap stocks: By buying them, you can set yourself up for success.
Small-cap stocks represent smaller companies, and smaller companies can grow quicker than large companies. Take a company that makes $100 billion per year in sales. To grow 10%, that company needs $10 billion more in sales. Now consider another company that makes $10 million per year in sales. To grow 10%, it only needs to increase sales by $1 million. Which sounds easier?
Now, it’s true that not every small company can just and make $1 million extra. But here’s the thing: Compared to large companies, small companies have only just started…their potential is likely higher.
Because I don’t like making claims without data, let me put this in numbers. From 1926 to 2006, the smallest 10% of companies provided an average of 14% return. The largest 10% of companies? 9.6%. That’s a difference of 4.4%. If you’d invested $1000 in small-caps in 1926 and let it sit, it’d have accumulated approximately 35 million dollars today (ignoring inflation). Large-caps? 1.5 million dollars. The difference is staggering.
The takeaway: Trust in small-cap companies. They have the potential for growth that large-cap companies salivate over.
Institutional investors have much more information than any individual investor could hope to have. This means that institutional investors are usually going to make better investment decisions.
But here’s the rub: They can only make better decisions when they have better information.
With small-caps, it’s the wild west. No one necessarily has better information and most of the information is hard to find. This is your chance. It’ll come down to your finesse and cunning.
Bumps in the Road
Of course, there are some downsides. With small-caps, the risks are bigger because small-caps don’t have nearly as much capital. This means that if things take a turn for the worse, the company could fold, and you could lose your entire investment. Similarly, small-caps are more vulnerable to wild swings in price.
Although risk is inevitable, there are some ways to mitigate its effects.
First, I recommend that if you’re looking to get into small-caps, you have a more long-term view. These companies could grow big and quickly, but if they don’t, don’t panic. Take Aurora Cannabis Inc. It hovered below $5 a share for 3 years. Near the beginning of 2018, it shot up to over $13 a share, or almost 500% return. You need to trust that small companies can make it big.
Second, look for small companies run by people who own stocks in that company and niche industry. These are going to be the executives with the extra motivation to make sure their companies are successful. Click here, search a stock ticker, and find a list of major holders for every stock for your edification.
Finally, look to buying small-cap company stocks especially right when the economy is restoring. When an economy is just climbing it way out of a recession, agile companies, which are usually smaller companies, are the ones that can quickly respond to the new wave of consumers. They have less in their way.
Bringing it all together, small-cap company stock can be a huge gain to your portfolio. They have better potential for growth, usually fly under the radar, and can be the first to lead the way out of a recession. Knowing the risks and protecting yourself against them can mean getting on the fast lane to big gains with small-cap stocks.
-Investing Insider Magazine