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What is a small cap stock? In general, companies that have market capitalization ranging from $300 million to $2 billion dollars are considered small cap. This number refers to the value of the company’s outstanding shares on the market. Large cap companies such as Boeing and General Electric usually have a market cap that exceeds $10 billion.

You can find market capitalization for a company by multiplying its share price by the number of current shares outstanding and then adding the market value of any market-traded bonds. Brokers may have their own definitions of small cap stocks, and the parameters of this category may evolve over time.

Market Capitalization Categories

As mentioned above, market capitalization categories vary by broker and over time. However, companies at the edge of one category or another pay close attention because their categorization impacts investment by mutual funds. In general, categories are as follows:

  • Market cap of $200 billion or more: Mega cap
  • Market cap of $10 billion or more: Big cap
  • Market cap of $2 billion to $10 billion: Mid cap
  • Market cap of $300 million to $2 billion: Small cap
  • Market cap of $50 million to $300 million: Micro cap
  • Market cap of less than $50 million: Nano cap

Market cap tells us more about the size of a company than stock price alone. A company with a higher stock price can still have a smaller market cap than its competitor with a lower stock price.

The categories have also evolved since the 1980s, when $1 billion was the common market cap for a large company. Remember that these sizes are flexible, and adjust your research and perspective accordingly.

Even today, mega cap stocks are relatively rare. Fewer than five companies fell into this category after the financial crash in the mortgage industry in 2008. Major tech firms such as Apple, however, are creating a resurgence of huge market caps.

Advantages of Small Cap Stocks

Have you dreamed of investing in the next Netflix or Amazon when it’s just out of the venture capital stage? Both of these huge global corporations were once small cap stocks.

Small cap stocks give individual investors a chance to win out over institutional investors. That’s because small caps do not have meaningful positions in mutual funds due to restrictions that prevent these funds from purchasing a majority of a company’s outstanding shares. Although mutual funds can bypass these limitations through a request with the Securities and Exchange Commission, doing so may inflate the low price of the small cap stock and make it less attractive.

Because these stocks often fly under the radar, they pose unique opportunities for investors who have the time to do their research and look for a diamond in the rough. This is in direct contrast to large cap companies, which make international headlines with every financial move.

It is a common misconception that small cap equates to small company. In fact, most of these firms have exceptional financial records and established histories. On the other hand, while large cap stocks are often considered stable, they also have the potential to result in significant losses for their investors, with Enron as the most notable historic example.

When reviewing historic data, small cap stocks typically do better than large cap stocks, but this depends on the economic climate over the time period in question. For example, during the 1990s tech boom, large cap companies such as AOL Time Warner, Cisco, and Microsoft were more attractive to investors than small cap companies. After the tech crash at the end of the decade and into the 2000s, small cap companies saw better returns as large cap companies lost value to the industry bubble.

The lack of red tape in smaller companies means they can pivot and expand quickly. The cycle from research and development to having a product out on the market is much shorter than for large cap companies. When a company is small, major successes can be quite lucrative for investors who get in on the bottom floor.

Disadvantages of Small Cap Stocks

Small cap stocks are typically more volatile and thus substantially riskier than large cap stocks, which are known for providing stability and long-term growth. However, they are still less risky than investing in a company that has not yet gone public. Small cap companies are more likely to file for bankruptcy and may be supported by just a handful of major clients.

Because these stocks have a lower trading volume, it can take time to finalize trades. This results in limited liquidity that can be frustrating for some investors. It may take longer to buy the shares you want or sell shares you want to offload.

In addition, limited market data can make it difficult to sufficiently research small cap stocks. In comparison, large cap stocks are subject to extensive tracking and analysis.

Small cap companies are also at risk for issues with corporate governance. That’s because a small group of executives, usually the chief financial officer (CFO), chief executive officer (CEO), and chief operating officer (COO), holds most of the decision-making power for the organization with limited checks and balances. This can result in errors that can severely impact a company’s future.

Small cap stocks rarely pay shareholder dividends. Most of their profits go back into the company to foster growth. If you want to build a portfolio that provides dependable quarterly income, it’s more advantageous to focus the lion’s share of your holdings in large cap stocks.

Exploring Midcap Stocks

If you’re looking for a compromise between small cap and large cap stocks, consider investing in shares of a midcap company. These firms are usually defined as those with a market cap falling between $2 billion and $10 billion and offer the growth potential of small cap companies with the stability of large cap companies. In fact, over the past 10 years, stocks in this category have performed better than both small and large cap stocks.

They are large enough to ride out downturns in the market without going out of business, a common fate of small cap stocks. At the same time, midcap stocks grow quickly when the economy is expanding as investors feel comfortable taking on more risk and turn away from stalwart large cap companies.

Diversifying Your Portfolio

Incorporating a mix of different size stocks in your portfolio can help you take advantage of the growth potential of small cap stocks while mitigating the risk. If you are not averse to a bit of risk, you can include a higher percentage of small cap and midcap stocks along with just a few large cap stocks. Conversely, if you want more stability, add just a few smaller cap stocks to a portfolio primarily holding investments in companies with larger market cap.

Economic Impact of Small Cap Companies

More than 65% of all new job growth in the United States comes from small-cap companies, which explains why firms in this category often find support from federal loans and grant programs designed to help small businesses. However, small cap companies have to be profitable enough to release an initial public offering (IPO), which occurs after significant private equity growth and the ability to demonstrate its stability and profitability to investors. At this point, these companies can be traded on the NASDAQ and New York Stock Exchange.

Trading Small Cap Stocks

The best place to get started with small cap stocks is the Russell 2000 index. This resource lists 2,000 of the small stocks trading on the public market. These stocks are also tracked by an exchange-traded fund (ETF) known as the iShares Russell 2000 ETF.

When deciding whether to invest in a small cap stock, look at these factors along with charts for each stock to conduct a detailed technical analysis:

  • Growth in earnings, which usually predicts future growth in stock prices. As sales growth occurs, make sure losses are decreasing each year as well.
  • Growth in revenue, which should be higher for a small cap company than it is for a large cap company. Declining revenue in a fledging firm can signal serious trouble with its business model.
  • The ratio of price to book (P/B), which looks at the book value of a stock compared to its actual costs. A low P/B ratio is a favorable indicator for a small cap stock.
  • The ratio of price to earnings (P/E), which can signify an undervalued company with a low ratio or an overvalued company with a high ratio. Compare P/E over time for the same company or among competitors in a target industry.
  • The ratio of price to sales (P/S), which is useful to learn more about companies without earnings. To find this number, divide the firm’s market cap by its revenue.

To learn more about trading small cap stocks, take advantage of the experts at Raging Bull. Sign up today as an insider to access free resources like e-books, webinars, and more from some of the most knowledgeable traders in the industry.

Author:
Jeff Williams

Jeff Williams is a full-time day trader with over 15 years experience. Thousands of entry-level and experienced traders alike – day-traders and swing-trade small cap stock traders – credit Jeff with guiding them to turning small accounts into big accounts.

Jeff’s "Small Account Challenge" shows people how to transform accounts from a few thousand dollars into $25k, $50k or even $100k.

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