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How to Invest in Small-Cap Stocks

Todd Campbell, The Motley Fool

Amazon.com is an e-commerce giant today, but it was a $5 stock with a $1.5 billion market cap in 1999. Similarly, Netflix is a household name now, but it was only a $2 stock with a market cap below $1 billion in 2004. Finding stocks like those early on makes small-cap investing incredibly enticing, but for every Amazon.com or Netflix, there are countless other companies that have started out as small stocks and failed.

Investing in small-cap stocks successfully means understanding the risks associated with them and how to separate good investments from bad investments. Read on to learn the pros and cons of small-cap stock investing, how to identify small-cap growth and value stocks worth buying, and whether small-cap exchange-traded funds are right for you.

What is a small-cap stock?

First, it's important to understand that it is market participants that determine a company's value. When investors talk about large-cap, mid-cap, or small-cap companies, they're referring to the size of a company based upon its market capitalization (the "cap" in "small-cap"). To calculate market capitalization, simply multiply the number of shares outstanding -- the shares currently held by all shareholders, including those owned by the company executives and other insiders -- by the current share price listed by a major stock market exchange.

For example, if a company has a total of 100 million shares outstanding and $10 per share was the last price quoted on a major market exchange, such as the New York Stock Exchange (NYSE), then the company's market cap would be $1 billion.

Many financial websites, including The Motley Fool, do the math for you and provide market capitalization for just about any stock you're interested in. For instance, scroll down on this ticker page from The Motley Fool to find market cap for the company.

Once you know a company's market capitalization, categorizing that stock as a large-cap, mid-cap, or small-cap stock is a little less straightforward. Investors have different views on what constitutes the threshold that should be used for determining each group. Nevertheless, a good rule of thumb is to consider a small-cap stock as any company boasting a market capitalization between $300 million and $2 billion.

A mid-cap stock will generally be any company with a market cap between $2 billion and $10 billion, whereas a large-cap stock is categorized as a company with a market cap greater than $10 billion. On the more extreme ends of this scale: Companies with a market cap below $300 million are usually referred to as micro-caps, whereas companies with market caps north of $200 billion (like Amazon) are considered mega-cap stocks.

Category Market Cap
Micro-cap companies $50 million to $300 million
Small-cap companies $300 million to $2 billion
Mid-cap companies $2 billion to $10 billion
Large-cap companies $10 billion to $200 billion
Mega-cap companies >$200 billion

The market cap of a company will tell you something about the company. Micro-cap and small-cap stocks are usually younger, less-stable companies with more uncertain futures, for instance. Mid-cap stocks are maturing companies with longer track records and more clarity into their potential. Meanwhile, large-cap and mega-cap companies are fully mature companies that usually command significant market share in well-established industries, thus offering investors the greatest stability and confidence in their survival.

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Why should you consider small-cap stocks?

Beyond the obvious potential of identifying the next Netflix in its early stages, investors often consider investing in small-cap stocks because historically, they've produced greater annual returns for investors than the mid-cap and large-cap stocks comprising the S&P 500 index, the gold-standard index used for measuring stock market returns.

The Russell 2000 index, comprising approximately 2,000 of the smallest stocks investors can buy or sell, is widely considered the benchmark index for measuring small-cap stock performance. To measure their performance, we look to the exchange-traded funds (ETFs) that track each of these indexes: the iShares Russell 2000 ETF (NYSEMKT: IWM) tracks the holdings of the Russell 2000, and the SPDR S&P 500 ETF (NYSEMKT: SPY) tracks the holdings of the S&P 500. By comparing the performance of these two ETFs, we find that, as a group, the small-cap stocks of the Russell 2000 have outperformed the mid-cap and large-cap stocks of the S&P 500 by an average of nearly 2% per year since 2000.

That outperformance has really added up for investors. Since Dec. 31, 2000, investors in the iShares Russell 2000 ETF have seen their money grow by 312%, while investors in the SPDR S&P 500 ETF have seen their money grow by just 226%.

Year SPDR S&P 500 ETF Return iShares Russell 2000 ETF Return
2018 (4.45%) (11.02%)
2017 21.69% 14.66%
2016 11.80% 21.36%
2015 1.34% (4.33%)
2014 13.53% 4.94%
2013 32.21% 38.85%
2012 15.84% 16.39%
2011 2.06% (4.19%)
2010 14.93% 26.76%
2009 26.42% 27.13%
2008 (36.97%) (33.64%)
2007 5.39% (1.47%)
2006 15.69% 18.17%
2005 4.79% 4.46%
2004 10.75% 18.15%
2003 28.39% 46.94%
2002 (22.12%) (20.51%)
2001 (11.86%) 1.97%
Average return 7.19% 9.15%

Data source: Yahoo! Finance.

Why doesn't everyone invest in small-cap stocks?

The Russell 2000's higher average return might seem to suggest that investing in small-cap stocks is a sure-fire route to greater investment returns. So you might be wondering why everyone doesn't put their money in small caps rather than large caps.

Here's why: If you look closely at the previous table, you'll notice that the Russell 2000's returns come not only with a greater risk of loss but also with more volatility. The median, or exact midpoint of annual returns, is 11.8% for the S&P 500 ETF and only 9.8% for the Russell 2000 ETF. Furthermore, the Russell 2000's 20.3% standard deviation -- a measure showing how volatile returns can be over time -- is notably higher than the S&P 500's 17.7%, suggesting that an investment in small-cap stocks can produce swings upward and downward that are significantly greater than the swings of stocks with larger market capitalization.

It is this risk of greater losses and more volatile returns that keeps many investors away from small-cap stocks. This is particularly true of investors who may need to withdraw their investment on a shorter time horizon, such as older investors who need to supplement their retirement.

Nevertheless, long-term-minded investors who are willing to accept the risk of losses and who don't need to tap investments anytime soon could find that including at least some small-cap stocks in their portfolio is worthwhile.

What specific risks face small-cap investors?

If small-cap stocks are right for you, then you should understand that the overall Russell 2000 index may overestimate returns and underestimate the risk associated with buying and selling individual small-cap stocks.

Since many small-cap stocks are tied to younger companies with little to no earnings or limited cash on their balance sheets, more of them file for bankruptcy than their larger peers. This is especially a risk during tough times, because small-cap companies rely on issuing shares to raise cash for operations more than large-cap companies do, and during economic or industry downturns, investors are less willing and able to buy newly issued shares to keep a company afloat, increasing the chances of the company facing bankruptcy.

Similarly, small-cap companies' diminutive size can mean that they are reliant on just one or two large customers, and that's a big risk. They also face competitive threats, such as new market entrants that drive the prices of products or services lower, and they might not be in a financial position to withstand the competition.

Small-cap investors also accept liquidity risks. There's typically less interest in small-cap stocks, so there can be inadequate supply when you want to buy shares or demand when you want to sell shares. Because average trading volume per day is usually much lower for small-cap stocks than for large-cap stocks, their prices may rise or fall by wider margins during any trading day. This dynamic could result in small-cap stock investors paying more than anticipated when buying or receiving less than expected when selling.

Additionally, since the companies behind small-cap stocks usually haven't issued as many shares as their larger-cap counterparts, C-suite leaders (CEO, CFO, COO, etc.) often have outsize ownership and dominant control over decision making. This can result in corporate governance risks, especially if a change in leadership is necessary.

It's also important to remember that smaller companies are often younger and therefore may not yet have adequate processes and controls in place in terms of financial accounting. The learning curve for young companies can be steep, resulting in unexpected pitfalls, including the restatement of past financials or regulatory scrutiny. For example, marijuana supply company KushCo Holdings had to restate its fiscal 2017 and 2018 financial results in 2019 after an internal review by its new chief financial officer discovered accounting errors related to acquisitions. Similarly, small-cap healthcare company MiMedx replaced its top management and disclosed it would have to restate at least five years of financial statements in 2018 after an internal investigation into sales and distribution practices. (The company's shares have since been delisted from the Nasdaq exchange.)

Small-cap investors can minimize risks like these by thoroughly researching the companies they're interested in and diversifying their portfolio across many different companies. Every quarter, publicly traded small-cap companies (in fact, all publicly traded companies) file a report called a 10-Q with the Securities and Exchange Commission. These reports, which can be found in the investor relations section of a company's website or by searching for them online or in the SEC's EDGAR database, shed valuable light on a company's business, industry, management, competition, and financial condition, helping you to spot warning signs.

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Do the pros of small-cap investing outweigh the cons?

Small-cap companies face many risks, but that doesn't mean investors should avoid these companies. Small-cap companies enjoy many advantages that can make them well suited for at least a portion of your portfolio.

Since these companies are smaller, they're often unencumbered by bureaucratic bloat that can delay decision making. Their ability to act fast can allow for quick incorporation of research-and-development discoveries into products or services. Their smaller size can also mean lower fixed costs, and shareholders may be more willing to forgo profitability in a company's early stages, allowing for greater flexibility when it comes to investing in and pricing products and services to win market share.

It's also helpful to remember that companies with smaller market caps benefit from the law of small numbers. Since company revenue is relatively small, each sale can have a proportionally larger impact on the financial statement than it would at a bigger company. This can result in many years of double-digit rates of revenue growth and, eventually, profit growth as these companies mature. For instance, a new six-figure account has much bigger impact on a small software company than it does on a giant like Microsoft.

Small-cap investors can also benefit by looking where others are not. Smaller companies are less followed by industry watchers, including Wall Street analysts, who usually concentrate on larger companies. Since the investment thesis associated with a small-cap stock might be underappreciated due to a lack of Wall Street research coverage, investors who buy early can benefit from rising interest if Wall Street starts to recognize the company's potential.

Given these advantages, owning at least some small-cap stocks can make sense despite the risks.

What should you look for when buying a small-cap stock?

Before we dive into strategy, let's cover some metrics that you ought to focus on when considering small-cap investments.

  • Revenue growth: Growth in revenue over time is particularly important for small-cap stocks, because younger companies should be able to deliver higher revenue growth than larger, more mature companies. If a company's revenue is declining, check to make sure its business model isn't broken.
  • Earnings growth: Stock prices tend to follow earnings growth over time, so year-over-year earnings (or net income) growth is important to track. Although many small-cap companies have yet to generate a profit, investors can be encouraged if losses are shrinking as sales are growing. If losses are increasing, you'll want to do more research to find out why, especially if revenue is also falling.
  • Price-to-earnings (P/E) ratio: This metric is useful for determining if companies with earnings (remember, some companies don't have earnings) are relatively overvalued or undervalued. A lower ratio may indicate a company is bargain priced, while a higher ratio may suggest a stock is too pricey. It can be useful to compare P/E over time or compare to the P/Es of competitors in the same industry. If you don't want to figure out the P/E for yourself, it's another metric almost any financial site will provide.
  • Price-to-sales (P/S) ratio: The P/S ratio is a company's market capitalization divided by its revenue. You can use this metric to evaluate companies that don't have earnings. Lower ratios are generally viewed as reflecting companies that are more favorably valued. However, price-to-sales ratios vary widely from industry to industry, so drawing apples-to-apples comparisons is particularly important. It wouldn't be fair to compare a low-price-to-sales consumer goods stock to a high-price-to-sales ratio technology stock, for instance.
  • Price-to-book ratio: It can also be useful to determine how expensive or inexpensive a small-cap stock is compared to its breakup value, or book value. Price-to-book is a company's market cap divided by its total assets (excluding intangible assets such as patents, goodwill, and liabilities). Again, a low price-to-book ratio may suggest a cheap stock worth owning.

Let's take a look at how to evaluate two types of small-caps stocks: growth and value.

How to invest in small-cap growth stocks

Motley Fool co-founder David Gardner's Rule Breaker investment approach can be very useful to help you separate the good from the bad in small-cap stocks, particularly for investors who focus on revenue growth and profit potential rather than valuation.

Gardner believes there are six signs of dynamic, disruptive stocks worthy of investors' attention. In his view, rule-breaking companies have:

  • A first-mover advantage or deep moat in an important or emerging industry
  • Visionary leaders
  • Identifiable competitive advantages
  • Good brands that people love
  • A track record of rewarding investors
  • Many detractors who are overly concerned with their valuation

If you can find each of these qualities in a stock, you may have uncovered a small-cap company worth buying. Let's see how Netflix measured up on this list back when it was a small-cap stock in 2004 (around the time David recommended buying it).

  • First-mover advantage: Netflix's mail-order DVD service gave it an early-mover advantage that posed a disruptive challenge to existing movie rental stores.
  • Visionary leaders: Netflix founder Reed Hastings had a master's degree in computer science from Stanford, and he'd already founded and sold a software company.
  • Competitive advantage: Netflix offered a convenience factor that gave it a big edge over rental stores.
  • Solid brand: The Netflix brand resonated strongly with consumers, given subscribers to its rental business had increased 73% to 2.2 million exiting June 2004.
  • Rewarding investors: It had already seen its shares more than double in value between the summer of 2003 and early 2004 before selling off that summer.
  • Concerned detractors: Finally, it also had its fair share of doubters, many of whom were concerned its forthcoming streaming service could cannibalize its existing mail-order business even as new mail-order competition was mounting from the now-defunct Blockbuster.

Fear over Netflix's valuation was one reason shares tumbled in 2004, giving investors like Gardner a nice entry into what has gone on to be a wildly successful investment. Netflix's return since 2004? A staggering 21,586% (no, that's not a typo).

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How to invest in small-cap value stocks

Today, Warren Buffett invests in mega-cap stocks like Apple through his company, Berkshire Hathaway. That wasn't always the case, though. He got his start using a value-style investment approach to identifying cheap, small-cap companies. In fact, Berkshire Hathaway was a small-cap textiles company when Buffett bought it in 1965, long before it became the behemoth conglomerate it is today.

Buffett's investment approach includes:

  • Avoiding capital-intensive businesses that require a lot of funding up front, such as utilities
  • Buying stocks when the market cap of the company is at a discount to its book value
  • Focusing on easy-to-understand businesses less likely to be disrupted by upstarts
  • Investing alongside top-notch, shareholder-friendly management teams

For instance, the consumer-goods candy company See's Candy was a particularly savvy small-cap investment for Buffett. When he bought it for just $25 million in 1972, it had about $30 million in sales and generated profits of $4.2 million. Today, he makes more than $100 million per year from See's Candy. Granted, stocks with See's-like financials trading at bargain prices don't come along very often, but it's worth taking notice when they do.

How to invest in a small-cap ETF

If scouring thousands of stocks looking for diamonds in the rough means spending more time and effort than you'd like, you may be better off buying a small-cap exchange-traded fund (ETF), because ETFs give you instant exposure to many small-cap stocks in a single click.

There are many small-cap ETFs to choose from, but you might want to focus your attention on the Vanguard Russell 2000 ETF (NASDAQ: VTWO). The iShares Russell 2000 ETF has a longer track record and more money invested in it, but Vanguard's fund tracks the same index, and it has lower costs.

Alternatively, you can consider investing in iShares Russell 2000 Growth ETF (NYSEMKT: IWO) or iShares Russell 2000 Value ETF (NYSEMKT: IWN). Neither specifically employs the Rule Breaker or Buffett style I outlined, but each focuses on growth- and value-oriented strategies. For example, the average price-to-earnings ratio and price-to-book ratio for stocks in the iShares Russell 2000 Value ETF are 12.5 and 1.3, respectively, as of July 25, 2019. Since the iShares Russell 2000 Growth ETF focuses on potential revenue growth instead, the average price-to-earnings and price-to-book ratios for the stocks it tracks are 25.7 and 4.18, respectively.

Is small-cap investing for you?

The question every investor who is interested in small-cap investing should ask is: How much risk can I afford to take? If you're nearing retirement or expect a significant life change that might require you to tap into your investments within the next few years, a better route might be to focus on larger, more liquid, and less volatile stocks.

However, if you're confident you won't need to tap into your investments for at least 10 years and you have an appetite for risk that can withstand potential losses, then small-cap stocks could be for you. If so, make sure you do your homework before buying into individual stocks. Similarly, if you plan to invest in a small-cap ETF like the Vanguard Russell 2000 ETF, consider owning it as part of a diversified portfolio that also includes mid-cap stocks and large-cap stocks.

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John Mackey, CEO of Whole Foods Market, an Amazon subsidiary, is a member of The Motley Fool’s board of directors. Teresa Kersten, an employee of LinkedIn, a Microsoft subsidiary, is a member of The Motley Fool’s board of directors. Todd Campbell owns shares of Amazon, Apple, iShares Russell 2000 Index, KushCo Holdings, Microsoft, and Netflix. The Motley Fool owns shares of and recommends Amazon, Apple, Berkshire Hathaway (B shares), Microsoft, and Netflix. The Motley Fool has the following options: short January 2021 $200 puts on Berkshire Hathaway (B shares), long January 2021 $200 calls on Berkshire Hathaway (B shares), long January 2021 $85 calls on Microsoft, short January 2020 $155 calls on Apple, long January 2020 $150 calls on Apple, short January 2020 $155 calls on Apple, and long January 2020 $150 calls on Apple. The Motley Fool recommends KushCo Holdings. The Motley Fool has a disclosure policy.