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What is a Small Cap Stock?

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Every company is different, but investors often group businesses by various characteristics. They may all share the same market, perhaps producing steel or supplying medical insurance. Other businesses are in the same type of industry, perhaps producing consumer goods or financial services.

Every public company has other, less obvious things in common: size, value, and financial characteristics. While you can't directly compare things like P/E ratio of two companies in different sectors or industries, you can compare companies of similar valuations.

For example, thirty of the largest American-based companies (sorry, Canadians!) are in the Dow Jones Industrial Average. You won't find a small company worth only a hundred million dollars there; these companies are worth billions (see Apple Computer or Exxon Mobil). Similarly, the S&P 500 market index contains the 500 most valuable companies, in terms of market capitalization, traded on US stock markets.

What about smaller companies?

What Is a Small Cap Stock?

You can imagine three ways of dividing stocks based on how much the market values them (the number of public shares outstanding times the value per share). The Dow and S&P 500 members have large market capitalizations. They're huge. Then you have midcap stocks, like those on the Russell 2000 index. They're probably worth more than a couple of billion dollars, but they're not enormous global conglomerates.

A small cap stock is a publicly traded business with a relatively small value; small cap in this case is short for small market capitalization. There's no single definition for small cap, but the range tends to be more than a couple of hundred million but less than a couple of billion.

That describes a lot of businesses.

Risks of Investing in Small Caps

Most stock performance studies concentrates on the big behemoths: the Coca-Colas and IBMs of the world. Why not? They're worth a lot of money, they have lots of shares traded every day, and they make huge revenues.

Yet because they're so widely studied, they're rarely undervalued. They don't have many surprises. They're often good stocks to own (they make a lot of money, after all), but they rarely provide good value investing opportunities.

Small caps aren't as attractive for the big institutional investors, for many reasons. In particular, a hedge fund worth $400 billion could buy a Canadian maple syrup company worth $200 million outright, so SEC guidelines are very strict about what mutual funds, hedge funds, and ETFs can and can't own (and how much). Small caps also have a lot less stock liquidity. There aren't as many shares available: a company worth $200 million might have a price of $20 per share and 10 million shares outstanding. It makes no sense to have 200 million shares outstanding, because then each share would be worth only $1 apiece, putting the company into penny stock territory.

Individual investors face a little more risk in investing in a small cap: it's not as easy to buy or sell (due to less liquidity) and there's less information available from other investors and analysts about the company and its financial position. Yet the benefits may be tremendous.

What are the Benefits of Investing in Small Caps?

Fewer analysts looking at a stock means fewer people trying to take advantage of an underpriced stock, so if you're confident in your ability to identify mispriced stocks, small caps can have lots of upside.

Better yet, because of their relatively small sizes, small caps can have the potential to grow into larger companies. It's a lot easier to take a company from a $1 billion valuation to a $2 billion valuation (an easy two bagger situation) than it is to take a company from a $1 trillion stock to a $2 trillion stock. There's a lot more room for growth! Not all small cap stocks have this opportunity, nor do they necessarily have the financial management to do so—but every large company on the S&P 500 started off as a smaller company at one point.

Should You Invest in Small Cap Stocks?

A good stock is a good stock. An undervalued stock is an undervalued stock. You can make money buying Coca-Cola stock at a great price just as much as you can make money buying Willamette Valley Vineyards at a good price.

Keep in mind what you're buying, though. Coca-Cola is an enormous company with cash reserves and financial options to weather a couple of bad years, while one or two bad years might just sink a small winery. Also remember that millions and millions of people own Coca-Cola stock and millions of shares trade hands every day, while only a few thousand winery shares get bought or sold. Getting into and out of a KO position is much easier.

As always, do your homework. Know your appetite for risk and understand what you're buying. Yet also know this: if you're really looking for mispriced stocks and opportunities to buy a good company with a lot of potential at a great discount, small cap stocks can help you build wealth in the stock market.