What are Small Caps?
Small caps refer to companies with a market capitalization generally ranging from $300 million to $2 billion. The market capitalization denotes the value of the outstanding shares of any company that trades on a stock exchange. However, a company’s market capitalization keeps on changing due to the fluctuations in the share price.
Small caps tend to perform well during the early phase of the economic revival. Investors seeking higher returns on their investments usually invest in the stocks of small caps.
- Small caps refer to companies with a market capitalization ranging from $300 million to $2 billion.
- The stocks of small caps are prone to market fluctuations; hence, these are highly risky investments.
- Small caps offer higher growth prospects, and they acquire capital in the meantime.
Small Caps and Investments
Investors looking to invest in the stocks of small caps should be aware of the following features of the stocks:
The value of stocks of small caps is greatly influenced by fluctuations in the market, which makes the stocks highly volatile. Hence, small-cap stocks tend to perform well during market uptrends and underperform when the market struggles.
Since the stocks of small caps are prone to market fluctuations, they tend to be affected more during the times when the market is hit – such as during recession – and take time to recover from them. Such market behavior makes the investment in small caps a risky option.
4. Return on investments
The shares of small caps are considered to provide a high return on investments. They can potentially become multi-baggers and yield more than 100% returns.
5. Cost of the Investment
In addition to the cost of acquiring the shares of small caps, there is an annual charge – known as the expense ratio – that investors need to pay. Investors investing in small-cap stocks with the lowest expense ratio tend to generate higher returns.
6. Term of investment
Both short-term and long-term options are available to the investors investing in the shares of small caps. However, it is recommended to invest in those shares that offer long-term investment options, so the associated risks are spread, and substantial returns are generated, too.
The gains received from investing in small caps are subjected to capital gain tax. If the shares were held for less than a year, the capital gain is taxed at the ordinary income tax rate. However, the long-term capital gain tax is applicable to returns on the investments held for more than a year.
Advantages of Investing in Small Caps
1. Higher growth potential
Historically, small caps have performed better than large caps in terms of growth. Small caps offer higher growth prospects, and they also acquire capital in the meantime. It enables them to enhance their growth prospects to a remarkable extent.
2. Fairly priced shares
Institutional investors would be restricted from buying huge portions of shares issued by small caps; hence, the stock prices would not go upward. It is because mutual funds adopt certain restrictions on buying portions of outstanding shares of any issuer. It provides an opportunity for small investors to beat the institutional investors and benefit from the fairly-priced shares of small caps.
3. Quality stocks at low prices
Small caps are under-rated, and their shares are undervalued due to possible inefficiencies in the market. Hence, with some research and evaluation of the market, investors can benefit by acquiring such quality stocks that are offered at low prices.
Risks Associated with Investing in Small Caps
The shares of small caps are prone to market risks, which can be minimized only in the long term by balancing the fund portfolio and allocating appropriate assets. Small-cap stocks provide investors with relatively lesser liquidity, and hence, make the sale process tedious.
Investors need time and research to determine the effectiveness of small-cap stocks as an investment option, and it is appropriate for investors with greater risk tolerance.
CFI is the official provider of the Capital Markets & Securities Analyst (CMSA)™ certification program, designed to transform anyone into a world-class financial analyst.
To keep learning and developing your knowledge of financial analysis, we highly recommend the additional resources below: