Companies can be classified based on revenue, size, and even market cap. Market capitalization is calculated by multiplying the number of shares in the market with the current stock price of the shares. Investors often refer to a company’s market capitalization to decipher its valuation compared to its peers.
Small- mid-and large-caps are categories for stock allocation according to the market capitalization of the respective companies. Blue-chip or large-cap stocks are shares of large companies. The market capitalization of large-cap companies ranges from $10 billion and higher. Small-cap stocks are shares of companies with a relatively small market capitalization, ranging from $300 million to $2 billion.
This type of categorization, however, can be misleading to investors if they make their investment decisions solely based on this differentiation. Many investors tend to believe that fortune favors large-cap stocks and that the way to gain considerable and sustained returns is by investing in large-cap stocks. Another common misconception is that small-cap stocks are only associated with start-up companies. In contrast, small-cap companies could be well-established institutions that are just small in their market size, and by virtue of that, have greater potential to deliver returns than some large-cap companies. Assumptions as discussed above, which are widespread among traders, can make them miss opportunities to earn high returns.
Today’s traders need to be aware of the growth potential of small-cap stocks. Small-cap stocks usually belong to growth companies that are expanding aggressively and have the potential to earn the status of large-cap companies in the future. In addition, small-cap stocks are available at lower valuations, thus making them ideal for growth investing. If you’re an investor exploring suitable investing strategies to grow and manage your portfolio, consult a financial advisor for further information and guidance.
Let us explore small-cap stocks in detail.
What are small-cap stocks?
By definition, a small-cap stock is a share of a company with a total market capitalization value ranging between $300 million to $2 billion approximately. Small-cap stocks tend to outperform the benchmark indices given the growth potential they have in catching up with the large-cap stocks. Thus, small-cap investors are constantly on the lookout for young companies that show signs of fast growth over the years. Investors seek to invest in these small-cap stocks that can become future large-cap companies and thus, gain significant capital gains.
Although small-cap stocks are a good investment alternative for those seeking quick capital appreciation, investors should keep in mind that these stocks are prone to high volatility. They tend to react to market news and factors faster than other stocks due to their smaller share base. They can therefore be at higher risk during the downtrends or the low phases of the market. Small-cap stocks would be best suited for investors with a high-risk tolerance, looking for short-term returns. However, risk-averse investors need not completely ignore these stocks if there are quality picks among them. Investors may always cushion the risks by including less volatile assets in their portfolios.
There are many advantages of investing in small-cap stocks:
- They have a greater potential for future growth compared to their large-cap counterparts. This presents the investors an opportunity to lock in higher capital gains in the future.
- There is a possibility that small-cap stocks are quality stocks but are fair-priced or low-priced because they are under-recognized by the public due to market inefficiencies. Thus, these are good picks for value and growth investing alike.
- Small-cap stocks are generally low-priced. This makes it affordable to the retail investors and enables them to purchase larger quantities of the stocks selected which may increase their earnings potential over time.
- Large institutional investors are bound by certain regulatory limitations to the quantum of exposure they can take in small-cap stocks. This prevents these stock prices from being artificially inflated due to the selling or buying pressures.
Small-cap investors, in return, earn an upper hand by being able to avail themselves of the small-cap stocks at relatively fair prices. But a major disadvantage associated with small-cap stocks is that they carry a higher risk compared to large and mid-cap stocks. Also, these stocks are less liquid as their trade volumes are not that high.
Therefore, traders must undertake in-depth research and analysis to find small-cap stocks worth investing in.
How can small-cap stocks affect your portfolio in 2022?
The U.S economy is surely recovering well from the economic blow it faced due to the covid pandemic in 2020. That said, it is still not free from supply chain bottlenecks and labor shortages. This explains the reason behind low-profit margins amongst most companies.
Generally, small-cap companies are domestic companies, so the impact of any economic or fiscal challenges that the country encounters is observed in their balance sheets. The effect of hurdles is more gruesome for small-cap companies than large-cap businesses.
While economists predict lower prospects of growth in 2022, given the aftermath of the pandemic effect on the economy, small caps could witness low returns from businesses. But they should still not be cut out from your investment portfolio simply because they now stand a chance at greater profits as the markets recover across the globe. The U.S small-cap index has been observed to outperform the S&P 500 index whenever economic growth accelerates. Therefore, it might be better to invest in small-cap stocks for the longer term in the current scenario.
In any case, it is advisable that you invest only after consulting your financial advisor.
How do small-caps perform during inflation?
Inflation and increase in interest rates reduce profit margins, but at the same time, they are signs of a strong economy. If the market expects the U.S economy to perform better than global trends, then increasing small stock exposure in your portfolio could prove to be profitable. On the other hand, exposure to small-cap stocks might lead to losses since they are more vulnerable to price changes than large and mid-caps. The total valuation of the Russell 2000 (the index that includes the smallest 2000 U.S companies by market capitalization) is around $6.7 trillion. In contrast, the total valuation of Apple alone comes up to $2.3 million. This proves that small-cap stocks will be more prone to volatilities in case of high volumes of inflows and outflows in the capital market.
Meantime, weaker economies tend to have lower interest rates, and inflation levels may or may not accurately reflect the strength of an economy. Knowing this, we can conclude that small-cap stocks would largely perform better when the central bank announces an accommodative stance on the monetary policy and underperform when the economy is faced with external pressures.
Small-cap stocks are more sensitive to future growth prospects of the economy than interest rate variations. The small caps will likely underperform if the interest rates fall due to an impending economic slowdown. But, once the interest rates hit bottom and the economic cycle turns positive, the performance of small-caps tends to improve.
If inflation is fairly stable and the economy shows good signs of growth, investors could consider investing in small-cap stocks.
The S&P Smallcap 600 gained 1.4% on average when the economy was experiencing deceleration and only 0.5% on months with high inflation growth. A similar trend has been shown by the Russell 2000 index, which gained 1.3% on average in months with low inflation but only 0.4% during months of accelerating inflation.
How can you invest in small-cap stocks?
Before investing in small-cap stocks, the primary thing to consider is your risk tolerance. Given their high volatility and low liquidity, they are highly risky investments. Alternatively, you may opt to invest in Exchange Traded Funds (ETFs) that track small-cap stock indices to ensure diversification and reduce single stock concentration risk. This may help minimize the overall risk to your portfolio to some extent.
Also, note that small-cap stocks can help balance a heavy-weighted portfolio and aid increase your overall gains in exchange for some additional risk. Large-cap stocks, by virtue of their inherently large market capitalization, react much less to market news and are mostly stable behemoths. This means the stock price of large-cap companies may move, albeit slowly. Small-cap stocks, on the other hand, react fast due to the fewer number of shares in circulation and therefore witness quick price appreciation (downfall too!). A mix of large-cap and small-cap stocks may be a good way to asset allocation to create an efficient stock portfolio that gives slow, stable returns through large caps and capital appreciation through small-cap stocks.
Investors could opt for some fundamentally strong small-cap stocks or even ETFs or small-cap funds targeting value stocks with low leverage and favorable sentiment. In the long run, the returns from small caps tend to outperform big-caps, so an investment horizon ranging from five to ten years may be necessary to comfortably earn a satisfactory level of return.
Investors with a suitable risk appetite may target to allocate 10% to 15% of their portfolio amount towards small-cap shares. In conclusion, investors may consider investing in small-cap stocks with a long investment horizon in mind.
To sum it up
Small-cap stocks are shares of listed small-cap companies that have a market capitalization of less than $2 billion. They are characterized by high volatility and low liquidity that gives them the highest potential for good rewards but also makes them highly risky investments.
Small-cap stocks tend to react instantly to market news and economic factors, unlike large-cap stocks that are stable and react less.
After judging the current scenario of high inflation levels and high-interest rates in the majority of the economies across the globe as they come out of the Covid-led pandemic, it may be best not to expect too much from market returns in the coming year. Inline, the segment of the small-cap stocks may also see the impact of slower business recoveries and taper tantrum – a scenario where the economy and markets react adversely to the Government slowly withdrawing the support it had extended during the tougher times (like the relief packages). Also, looking at the recent surge of the Omnicron virus in Europe and other economies, the global economic environment might suffer pressures which might again lead to underperformance on behalf of small-cap stocks. Nevertheless, the markets are always unpredictable. It may be advisable for investors to not remove small-cap stocks from their existing portfolios as they may give market-beating returns once the economies get back on their track of economic recovery and growth. Investors can also consult their financial advisor before buying into the small-cap stock to know if it’s the most suitable investment strategy for their financial needs.
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