- Small-cap stocks are companies that have a market capitalization value between $300 million and $2 billion.
- Small-caps are often new companies, focused on a niche market, or struggling financially.
- While small-caps tend to be volatile and rarely offer dividends, they have a lot of growth potential and are often undervalued.
One of the most important metrics for investors when evaluating a company’s stock is its market capitalization, or the total value of its outstanding shares.
While the focus tends to be on the biggest ones like Apple, Amazon, and Microsoft, small-cap stocks can also be a source of much excitement in the stock market.
What are small-cap stocks?
Small-caps (short for “small capitalization”) are companies with a market capitalization of less than $2 billion. That may sound like a lot, but that figure makes them fledglings in the financial world. They are often young companies with massive room for growth.
But not all small-caps are newcomers. While they have the potential to grow into mid-cap or large-cap companies, it works both ways. If a mid-cap or large-cap company sees economic and business challenges that cause them to lose value, they can become small-caps.
Because they’re often expanding fast, you’ll frequently see the biggest price gains coming from companies in the small-cap category. As a group, small-caps tend to perform well. But betting on any individual company is especially risky. Many small-cap companies never quite make it off the ground or fulfill their early promise.
A small-cap stock is generally classified as one whose market cap is between $300 million and $2 billion.
It’s a diverse group, in several ways. For one thing, companies within it belong to a variety of industries, ranging from the traditional to the high-tech. Many focus on a particular niche within a sector.
Some of the better-known small-caps include:
- Denny’s Corp, the family restaurant chain
- Rocket Companies, the real estate, mortgage, and e-commerce company
- Eventbrite, the event management SaaS company
- Energy Recovery Inc., a company that manufactures fluid flow systems
- Rhythm Pharmaceuticals, a drug manufacturer
Because of their potential for substantial appreciation, small-cap stocks often overlap with growth stocks — companies on a fast track, that are outperforming the market overall in terms of return.
But they’re not all bright young things. Some are so-called fallen angels — once larger companies that have declined in value. Some may have shrunk deliberately, to better focus on their core business or a particular market. Others may be struggling or even on the brink of bankruptcy.
Characteristics of small-cap companies
Small-caps are a highly varied group, but they tend to share some similarities.
- They’re — you guessed it — little guys. These companies are often limited in size or outreach or both. They may be regional or not yet well-established in the field. That means they have lots of room to grow, but also lots of room to fail. They may also become acquisition targets for larger corporations.
- They rarely provide income. Many small-caps don’t pay dividends, preferring to reinvest their profits back into the company for further growth. They’re not a great choice for income investors.
- They’re volatile. Many small-cap stocks attract excitement — but not a lot of actual investors. Their trading volume is low. That, along with their general lack of track record, means they tend to see large or sudden swings in price.
What can investors expect from small-cap stocks?
The one predictable thing about small caps is their unpredictability.
“Small-cap stocks can have significant growth potential and often remain undervalued by the market,” says Asher Rogovy, chief investment officer at Magnifina, a portfolio management firm. In fact, small-caps have historically performed quite well over the long-term, even better than large-cap stocks, whose big-growth days are behind them.
In fact, according to Dr. Robert R. Johnson, professor of finance at Creighton University, from the late 1920s through the early 21st century, small-caps on average have consistently beaten the annual returns provided by large-caps.
But as a rule, small-caps are much higher-risk than large-caps. The problem is the volatility — the large swings in stock price. Sometimes those swings go in your favor and you can win big. But you could lose big, too.
Over the years, you may well come out ahead, but it could be a stomach-churning ride along the way. And the timing could be tricky if you need to cash in for a specific financial need or emergency.
Small-caps may be getting more scarce
Exciting small-caps may not be easy to find as they used to be.
“A fast-growing company will often not go public until it reaches a medium size,” says Alan Vaksman, co-founder of tech-oriented investment company Digital Horizon. “Companies can afford to stay private attracting, for example, venture capital investments.” Or using crowdfunding platforms for financing.
Case in point: Airbnb, which went public in December 2020. The home-rental company stayed private until it had massive revenue. And then when it held its IPO, it jumped right to the ranks of the large caps, with a capitalization of more than $90 billion. So it skipped the small-cap step.
“The small-cap segment is filled with small traditional businesses, like local banks and insurance companies, manufacturers, and so on,” Vaksman says. “Their potential growth is more limited.”
The bottom line
Small-caps have some of the highest rates of growth among stocks, which is what makes them so attractive. But they also are more volatile, with an untried track record — or a troubled one. All this poses a greater risk for investors.
Because of the massive diversity in small-cap companies, Tricia Rosen, principal at Access Financial Planning, suggests doing your due diligence.
“Ask yourself why a company is a small-cap before investing in it,” Rosen recommends. “Is it just starting? Is it struggling and shrinking in size? Is it projected to stay small with steady performance? The appropriate investor for each situation may be different even though each is a small-cap.”
If you’re looking for stable investments, you’re probably not in the market for small-caps. But if you’re seriously looking for the Apples and Amazons of tomorrow, some small-cap speculation — carefully considered, of course — might be for you.