Investing in Small Cap Stocks

Small-cap stocks can be some of the most exciting stocks you ever own, with immense growth potential that rewards you …

Small-cap stocks can be some of the most exciting stocks you ever own, with immense growth potential that rewards you handsomely. They can also be extremely volatile, carrying more risks than mid- and large-caps. Though they’re certainly not for the faint-of-heart, small-caps could have a place in your investment portfolio, especially if you’re interested in picking out growth stocks. 

What exactly are small-cap stocks, and how can you pick them wisely? Below we’ll discuss small-caps in more detail. 

What are small-cap stocks? 

A small-cap is a company whose market capitalization falls between $300 million and $2 billion. Small-caps are often young companies with immense growth potential, but less profits and stability than older, more established companies. They can be extremely volatile, though over long periods of time, they tend to outperform mid- and large- caps.  

What should you look for in small-cap stocks?

To find truly great small-cap stocks, you have to learn to separate the bad from the good. Here are three ways to start digging for the best small-caps. 

1. Look for “explosive” ideas 

First, look for companies that have the potential to disrupt entire industries. For instance, you might look for companies that have a solid line of products (or ideas) that no other company in their industry is offering. Or you might look for a company that has a compelling business model or a way of earning revenue that differs from others. Or you might look for companies that are using technology in ways others just aren’t. 

Take banking, for instance. Many bank stocks are attached to banks that continue to do things the way they always have. But plenty of small fintech companies are challenging this traditional model with touchfree banking services, robo-investing, and even broker-free mortgages. These companies (often small-caps) are worth watching, as they could easily attract scores of people from all generations. 

But new tech companies aren’t the only industry disruptors. While, yes, in the past decade, many of the most innovative companies have been tech, we’ve seen retailers (lululemon) and consumer discretionary companies (Tesla) take a stab at convention. Even a company like Monster Energy Drinks disrupted the soft drink industry by throwing together an insane amount of caffeine and sugar. You just have to keep your eyes open for potentially explosive ideas. 

2. Find strong businesses 

A good idea means nothing if the company isn’t making money. In order for a small-cap to realize its explosive potential, it needs to have a strong business to back it up. While finding strong businesses may require you to dig deeper than the surface, a few metrics can help you do the dirty work:

  • Revenue growth: If a company isn’t making money, it’s probably losing money. And that’s definitely not the kind of small-cap you want to invest in. In general, look for a company with at least a 20% revenue growth, as well as a long history of growing revenues. If a company’s revenue isn’t growing steadily over time, proceed with caution. Often, small-caps that stop growing are small-caps that never pick up the momentum they need to become bigger stocks. 
  • Total addressable market (TAM): The total addressable market is the total revenue opportunity available to a company. Basically, the TAM tells you how big a company could get if it hit its maximum limit. Many small-caps will cite their TAM during shareholder meetings as a way to show just how much potential they have. While the TAM alone shouldn’t convince you to invest in certain small-caps, if the stock in question has a strong business model with disruptive potential in a market with a massive TAM, you may have found a stock that will make you rich. 
  • Past price appreciation: Another good indicator of a strong business is an upward trend in stock prices. If a small-cap has never gone above it’s IPO price, or if it’s trended downwards or flat for a long period of time, it might not have much explosive potential. Stocks that explode are usually stocks that have been trending upward for some time. While there are expectations to this, it’s best to look for small-caps with a tract record of stock market growth. 

3. Pay attention to value 

Finally, you can use evaluation metrics to understand just how much value a stock truly has. For instance, you can use the P/E ratios to compare a stock’s price to the company’s earnings. If the stock is extremely expansive, but the company isn’t making that much money, the stock may be overpriced. Likewise, if the stock is making lots of money, but the stock price is low, you may have found a deal. 

Where can you buy small-cap stocks?

When it comes to finding small-cap stocks, you don’t have to look far. Many of Canada’s best online brokers will allow you to trade shares of small-caps at low or no fees. Of course, unlike stocks with larger caps, brokers may not give you a ton of information on small-caps (like stock analysis or performance reviews), forcing you to find that information yourself. 

If you’re not the kind of person who enjoys picking stocks, you could buy shares in a small-cap-focused exchange-traded fund (ETF). Basically, with an ETF, you’ll spread your money across numerous different small-cap stocks. Your ETF manager will pick the stocks for you, and your shares will grow as the cumulative performance of all the small-caps grow. 

What are the risks and rewards of small-cap stocks? 

The main reason to invest in small-caps is to get immense returns. Unlike many large-caps, which offer security but limited growth potential, small-caps could give you life-changing growth. Many small-caps end up being the kinds of stocks investors wish they had invested in before they grew into large- or mega-caps. When you hear people say “I invested in Shopify when it was just starting out,” you’re hearing a story of successful small-cap investing. 

But, of course, for every small-cap that becomes a Shopify, there are thousands of small-caps that fizzle out. Perhaps the greatest risk with small-caps, then, is the fact that they lack the resources that bigger companies have. Many just aren’t profitable yet, which is okay for the short-term, but devastating for the long run. If a small-cap company can’t bring its products or services to the market, if they don’t catch on like you assumed they would, they could easily fail, especially if the market or economy takes a turn for the worst.  

In addition, small-caps are often far more volatile than other stocks. While, sure, all stocks have certain degrees of volatility, small-caps are far less stable, with price movements that raise and fall several percentiles within a single day. If you’re risk tolerance is fairly low, you may not feel comfortable with a small-cap’s wild swings. 

When is the best time to invest in small-caps? 

Small-caps tend to grow substantially in bull markets, while bear markets tend to cause small-caps to shrink. The reason is fairly simple. During bull markets, a stronger economy gives small-caps more space to capture consumers’ attention. During bull markets, consumers typically have more discretionary income, allowing them to try new products and services.

Are small-cap stocks right for you? 

Small-caps are a great way to gain immense wealth. But they’re not for everyone. If your risk tolerance is fairly low, or if you’re near retirement, you may want to stick with safer investments, such as large-caps and blue chips. Alternatively, because many small-caps are relatively unknown, you might want to stick with companies you understand, especially if you’re not the do-it-yourself type who will spend hours researching new stock picks. 

That said, small-caps are great for investors who want to earn more than blue chips, large-caps, and index funds typically allow. They’re also ideal for investors who have a long time horizon, that is, for young (or relatively young) investors who have a long way until retirement. Since many small-caps are just getting off the ground, it could take years before they hit their growth potential, with many ups and downs along the way. As long as you take a buy-and-hold strategy, focusing on long-term growth and not short-term price movements, you’ll put yourself in a good place to earn the utmost growth. 

Keep in mind, however, that investing in small-caps can be risky. You definitely want to do your homework before you buy shares in a small-cap company. While the growth potential on small-caps can be amazing, the losses can be devastating. Use evaluation metrics and analysis to dig into your stock picks, and you’ll avoid investing in a dud.