Small Caps

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 fair market value of the outstanding shares of any company that trades on a stock exchange. However, a company’s market capitalization will constantly change due to the fluctuations in the share price.

Small caps tend to perform well during the early phase of the economic cycle. Investors seeking higher returns on their investments usually invest in the stocks of small caps.

Small Caps and Investments

Investors looking to invest in the stocks of small caps should be aware of the following features of the stocks:

1. Volatility

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.

2. Risk

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 higher risk.

4. Return on investments

The value of shares of small caps are relatively small, but can increase two or threefold quite rapidly. 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, many funds charge an annual fee – known as the expense ratio – to manage the fund Investors that can find funds that invest 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 small caps for the long term to allow time for those companies to grow and increase in value.

7. Taxes

The gains received from investing in small caps are subjected to capital gains 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 may require capital to enhance their growth prospects.

2. Fairly priced shares

Institutional investors try to restrict themselves from buying large blocks of shares issued by small caps; as this reduces the liquidity of the shares Liquidity is essential to providing open trading of a small cap’s stock which is essential to creating fair prices for shares.

3. Quality stocks at low prices

Small caps are sometimes 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 found at low prices.

Risks Associated with Investing in Small Caps

The shares of small caps are prone to market risks, which can be reduced through portfolio diversification. Small-cap stocks are also less liquid or harder to sell, because there are smaller pools of investors interested in these companies.

Investors need to spend sufficient time to research small-cap stocks as an investment option, and they are more appropriate for investors with greater risk tolerance.

More Resources

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