Small Cap Stocks can Pop

Small cap stocks can deliver a big pop, which can be either the sound of your investment doubling or the sound of your investment blowing up.

Small cap stocks are companies with a market capitalization of $1 billion or less. By way of review, you calculate market capitalization or market cap by taking the number of outstanding shares and multiplying by the current per share price.

Some investors put the mark for small cap stocks at a lower figure, while others put it higher. There is no one figure everyone agrees is correct.

Risky Business

What most experts do agree on is that small cap stocks, especially those with market caps under $500 million are risky investments.

Let me be clear. I am not talking about penny stocks – those micro companies that trade off the Nasdaq for literally pennies per share. I’m referring to the stocks of small companies you can buy and sell on a listed exchange.

Small cap stocks are risky because:

  • Big fish eat small fish in a competitive market. You can have a great idea and a great company, but a larger competitor can kill you.
  • Market and/or economic reversals can be devastating to smaller companies that often lack the financial resources to hold on through tough times.
  • Many small companies are started by people with a great idea, but no business experience. If they fail to learn how to run the business or refuse to turn the business over to professional managers, the company is at risk of failing due to poor management.
  • Evaluating small cap companies is sometimes difficult due to the lack of information or historical data. Short operating histories make analysis seem more like guesswork.

What’s Good about Small Caps

Despite the risks associated with small cap stocks, there are some good reasons for considering adding them as a modest portion (usually no more than 5% - 10%) of your portfolio.

The first place you can start is the obvious: the most successful companies today started as small companies. Who knows where the next Microsoft is coming from, but it will certainly have started out as a small company.

Here are some other good points about small cap stocks:

  • It is easier to double the sales of a company doing $20 million per year than it is to double the sales of a company doing $2 billion in sales. Rapid growth is easier for small cap stocks.
  • Smaller companies can “fly under the radar” of intense market attention longer. This keeps the price from being bid up too high or knocked down too low. Most mutual funds, for instance, don’t invest in small cap stocks. (The exception, of course, would be funds that specialize in small cap stocks.)
  • Small companies tend to be more nimble and react quicker to market and technological conditions. Small companies can exploit opportunities that larger companies can’t afford to chase because of their huge overhead.

What to Look For

How do you find a good small cap stock? It requires more work than investing in larger, better-followed companies since there may not be much information available.

Here are some tips:

  • Invest in what you know. If you have expert knowledge or extensive experience in a particular industry or technology, this may be a good place to start looking. It is always important to understand what you invest in, but doubly so in small cap stocks.
  • Avoid “bleeding edge” technology, because this is so risky on its own, when coupled with small companies becomes a complete gamble.
  • Be realistic. The company has to have a chance to succeed, but if it has a huge debt load and no cash, what chance does it have?
  • Be patient. Plant your seed and let it grow. Investing in small cap stocks is definitely a “buy and hold” strategy.
You can find small cap stocks using one of several stock screens online. One that I like for this purpose is BusinesWeek Online. It lets you put in a minimum and maximum market cap so you can focus on specific size companies if you wish.
(By Ken Little)