Should You Invest in Small Cap Stocks?

Small cap stocks can be a great supplement to any portfolio as long as an investor puts in their due diligence researching the stock and is comfortable with the increased risk that comes with investing in smaller companies.  There are many different definitions of what constitutes a small cap stock but a good rule of thumb is any company with a market capitalization of less than $1 billion and more than $250 million.

Opportunities with Small Caps

1.       Growth

Small cap stocks have a lot of potential for growth.  At some point most of the large cap stocks traded on the market were small cap investments that took off.  If one manages to make an investment in a company like this early the benefits are substantial.  It’s far easier for a company with a capitalization of $500 million to double in size than it is for a company work $50 billion to do the same.  So even if a small cap investment isn’t the next Wal-Mart there is opportunity to see growth in an investment that far exceeds large cap investments.

2.       Lack of Coverage in the Market

Market analysts naturally pay a lot more attention to the major players in the market as by their nature far more investors have an interest in those companies.  This creates an opportunity for individual investors who put in the time to identify small cap stocks that are mispriced in the market or that have large upsides that other investors simply haven’t had the chance to see.

3.       Many Institutional Investors Ignore Them

Institutions like mutual funds and pension funds don’t typically invest much money into small cap investments.  They make investment decisions that see hundreds of millions of dollars moving one way or another and your average small caps don’t have the size to absorb this kind of investment easily.  This leaves opportunities for individuals to invest in a sector of the market that is ignored by a huge proportion of the investor pool.

The Downside of Small Cap Investing

1.       Risk

Small caps are inherently more risky to invest in than blue chip companies that have proven their ability to grow and consistently generate a profit.  For every small cap that became a major player there are dozens of companies that faded away or were acquired by one of their competitors.
Due to their relative size they are at far more risk of going out of business if their local market experiences hardship.  Large established companies often have globe spanning operations that allow them to weather out tough times in a single area.

Aside from market risks they are also more susceptible to going out of business if they experience any major problems.   A large company that experiences a bad management decision or a product failure can absorb the financial impact and move on.  A small cap that experiences the same thing can go bankrupt.

2.       Time Commitment

Due to the nature of small caps being under reported in the market, as discussed above, you have to do a lot more of the footwork yourself to ensure the company is a good investment.  This means you’re going to have to prepare your own financial analysis and assessment of the company’s health as an investment opportunity.  Many individual investors shy away from this as they don’t have the time or the skills to do this.

So, Should You Invest in Small Cap Stocks?

Yes.  As long as you can take the time to do some of your own research and accept the risks involved with seeking out the potential high returns.  Every portfolio of investments has a degree of risk involved and as long as your portfolio and your investment strategy can absorb the risks of investing in small cap stocks they can be a great opportunity.

 

--Jeffrey Glen
By InvestorGuide Staff

Copyrighted 2016. Content published with author's permission.

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