Small-Cap Stocks: Definition and Characteristics

August 31, 2024 4 min read Finance Investments Small-Cap Stocks Market Capitalization Stock Market Investments Volatile Stocks

Small-cap stocks are shares of public companies with a relatively small market capitalization. They generally carry higher growth potential along with increased volatility and risk.

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Definition

Small-cap stocks refer to the shares of public companies that have a relatively small market capitalization. Market capitalization, commonly known as market cap, is calculated by multiplying a company’s current share price by its number of outstanding shares. Generally, small-cap companies are considered to have a market cap within the range of $300 million to $2 billion USD.

Key Characteristics

Higher Growth Potential: Small-cap stocks are often perceived to offer higher growth potential because they are in the growth phase of their business cycle. They may have more room for expansion compared to larger, more established companies.
Increased Volatility: These stocks tend to exhibit more price volatility. The smaller market capitalization often means limited trading volumes, making their stock prices more susceptible to sharp fluctuations.
Higher Risk: Due to their smaller size, these companies are often more vulnerable to market pressures and economic downturns. They may also have less diversified revenue streams and fewer financial resources than larger companies.
Less Analyst Coverage: Small-cap stocks receive less attention from financial analysts compared to mid- and large-cap stocks. This can lead to less publicly available information and may create inefficiencies in their market pricing.

KaTeX Formulation

Let $P$ represent the current share price and $N$ represent the number of outstanding shares. The market capitalization ($MC$) is given by:

MC = P \times N

For small-cap stocks:

300\ \text{million} \leq MC \leq 2\ \text{billion}

Types of Small-Cap Stocks

Growth Small-Caps

Growth small-caps are companies that are experiencing rapid sales and earnings growth. They reinvest most of their profits back into the business to fuel expansion.

Value Small-Caps

Value small-caps are companies that may be undervalued based on their current fundamentals. They typically trade at lower price-to-earnings (P/E) ratios and price-to-book (P/B) ratios compared to their growth counterparts.

Micro-Cap Stocks

Micro-cap stocks are an even smaller subset within the small-cap category, typically having market capitalizations between $50 million and $300 million.

Special Considerations

Liquidity

Small-cap stocks often face liquidity challenges, meaning their shares might not be easily convertible to cash without affecting the market price significantly.

Due Diligence

Investing in small-cap stocks requires thorough due diligence. Investors should investigate the company’s financial health, competitive landscape, and growth prospects.

Examples

Company A: With a market cap of $500 million, Company A shows strong revenue growth but also exhibits significant price volatility.
Company B: Valued at $1.5 billion, Company B is a small-cap stock that is under-valued based on its assets and earnings.

Historical Context

The popularity of small-cap stocks has grown considerably since the late 20th century as investors seek higher returns in an increasingly competitive market landscape. Historically, small-caps have experienced more substantial gains during economic upturns but have also faced more significant declines in downturns.

Comparisons

Small-Cap vs. Mid-Cap

Mid-cap stocks have larger market capitalizations, typically between $2 billion and $10 billion, and offer a balance between growth potential and stability.

Small-Cap vs. Large-Cap

Large-cap stocks have market capitalizations above $10 billion and generally provide more stability and consistent dividends but lower growth potential compared to small-cap stocks.

Market Capitalization: The total market value of a company’s outstanding shares.
Volatility: A statistical measure of the dispersion of returns for a given security or market index.
Earnings Growth: The annual rate at which a company’s profits increase.

FAQs

Are Small-Cap Stocks Suitable for Long-Term Investment?

Yes, but they come with higher risk and require careful selection and monitoring.

How Can One Invest in Small-Cap Stocks?

You can directly invest through individual stock purchases or indirectly through small-cap mutual funds and exchange-traded funds (ETFs).

What Are the Risks Involved?

Higher volatility, lower liquidity, and less available public information are primary risks.

References

“Investing in Small-Cap Stocks.” Investopedia. Link
“Small-Cap Stocks Guide.” The Balance. Link

Summary

Small-cap stocks are shares of companies with market capitalizations between $300 million and $2 billion. While they offer significant growth potential, they also come with higher volatility and risk. Thorough due diligence and strategic investing can help leverage their potential for substantial returns.