Small cap stocks (stocks with a market capitalization between $100 million and $1 billion) are a great space to look for long-term gains. Certainly, stocks with a smaller market cap can be riskier, and they can be volatile.
Small cap stocks are volatile simply because they don’t have the liquidity of large cap stocks. As a result, they tend to have a lot more retail investor ownership. That can mean that there is a lot more trading in and out of the stock.
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Big opportunities exist for small cap stocks
That is also where the opportunity exists. You can buy these companies before big time institutions and index investors add these stocks to their portfolio. When the big institutions engage, you can see a huge pop in the stock price.
If a company is executing its strategy, managing its balance sheet, and steadily growing its business, it can get the benefit of earnings growth and valuation multiple expansion. The combination of these two levers can help a stock rise and multiply for years.
A case study on a small cap stock that created immeasurable wealth
If you are looking for an example consider Constellation Software (TSX:CSU). It completed its initial public offering (IPO) in May 2006. CSU had an initial market cap of $386 million.
The company had a really smart CEO who was using the IPO proceeds to consolidate specialized software businesses. These businesses had small, limited markets. However, they were often cheap to acquire and highly cash-generative.
He took the cash and re-invested into more businesses. It turns out there are thousands of these businesses available to be acquired. Nearly 19 years later, Constellation’s stock has risen by 26,940%! It has compounded by a 34%-plus annualized rate!
Today, Constellation has a market cap of $104 billion. Given its large size, returns are likely to moderate. Its bread and butter of small acquisitions are not likely to move the needle as quickly. CSU is still likely a good investment, but smaller cap stocks could present more upside.
A software business that could set long-term gains
One stock that is still in its early innings of its growth phase is VitalHub (TSX:VHI). It has a market cap of $635 million.
Like Constellation, it operates niche software firms, focused on the healthcare industry. The tech provider to the health and human services sector has solutions focused on patient care/management, patient flow, and workforce automation.
Healthcare systems are incredibly pressed due to high demand, limited budgets, and inefficient operations. Demand for efficiency solutions should only grow in the years to come.
VitalHub offers software solutions around the world. Consequently, it can be very opportunistic with its acquisition strategy. It has made over 17 acquisitions to date. With a cash-rich balance sheet, it is primed to continue its acquisition growth strategy in 2025.
In 2023, VitalHub hit a positive inflection point. It started to generate substantial excess cash from its operations. Free cash flow continues to accelerate.
VitalHub has an invested management team and plenty of areas for organic and acquisition growth. It is not the cheapest small cap stock today. However, buy this stock with a long horizon and it could substantially pay off in the years ahead.
