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Investing in Small Cap Stocks: How to Do It and Why You Should

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By Susan Paige

Frugal Feature

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In the world of trading, it’s important to be aware of each company’s standing, both currently and potentially. Market capitalization plays a big role in trading decisions, and for good reason. Keep reading to learn more about market capitalization, the benefits of investing in small-cap companies, and how to pick the best ones.

What Is Market Capitalization?

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Market capitalization, or market cap, is the total value of a company’s outstanding shares on the stock market. In other words, it’s how much money it would cost you to purchase all of a company’s shares at the current market price. This number is calculated by multiplying the current market price of one company share by the total number of outstanding shares. When talking about market capitalization, companies can fall into one of three major categories:

  • Small-Cap: These companies have a market cap between $300 million and $2 billion. This may seem substantial, but these companies are usually fairly new, serve a niche market, or are in a newer industry. Because of this, these smaller companies are often considered high-risk investments.
  • Mid-Cap: Mid-cap companies usually have a market cap of $2 billion to $10 billion and are considered more established than small-cap companies. These companies are usually in the process of expanding or are in an industry that is rapidly growing.
  • Large-Cap: Also referred to as big-cap, large-cap companies have a market cap that meets or exceeds $10 billion. These are usually companies that have been around for quite some time and operate as top competitors in well-established industries.

Why Invest in Small-Cap Stocks?

Small-cap investing carries risks, but there are several advantages that make it worthwhile. They:

  • Get less attention from Wall Street: Small-cap value stocks regularly outperform large-cap companies as an asset class because they get less attention and minimal analyst coverage. This causes small-cap stocks to be undervalued and earn much higher returns.
  • Have fewer large investments: Unlike large-cap companies, small-caps often don’t have the market cap to support huge investments from mutual funds. This allows individual investors to spot and invest in a promising company before institutions are able to get in and drive up the price.
  • Have great growth potential: Every big company was once a small-cap. When you invest in a small-cap, you have the potential to grow even a small investment into a small fortune.

How to Decide Which Small-Cap Stocks Are Worthwhile

As with any investment, there are a number of strategies you can employ to make more informed trading decisions. Here are some helpful tips to guide you as you invest in small-cap stocks:

  • Look for stocks that pay sizable dividends: With small-cap stocks, dividends higher than 2% are preferred.
  • Search for companies with less debt: A good cash position usually signals that a small-cap can weather tough times.
  • Review the fund’s turnover ratio: This tells you how often fund holdings are traded. When there are high turnover ratios, it usually results in higher trading costs.

Investing always comes with its fair share of risks, and small-cap stocks are no different. By learning strategies for choosing the best small-cap stocks, you can minimize these risks and earn an impressive return on your investment.