What Small-Cap Stocks Are & How to Invest in Them

Investing in Small-Cap Stocks Made Easy

Small-cap stocks are, metaphorically speaking, diamonds in the rough. If you find the right one and polish it up nice, it can sell for a fortune. But one wrong cut and it could be rendered worthless.

So finding the best small-cap stocks is more skill than luck.

It’s true that some investors have struck it rich overnight with a few lucky picks here and there. But nearly all of the bigwigs in the investing game have made it through skill and discipline. Just look at Warren Buffett. The billionaire investor picked some rough diamonds early in the game with skill, not luck (although the latter may have also played a part).

The truth is, small-cap stocks have historically performed better than large-cap stocks. Here’s why.

If you start blowing into an already inflated balloon, it can only grow so much. Blow some more and it will burst. But partly inflated balloons have the capacity to fill up more. Small-cap stocks are like partly inflated balloons that have room to grow.

Now, I understand that novice investors have many questions. What are small-cap stocks? Are they risky? Should I invest in them? How do I find the best small-cap stocks?

Worry not! Here’s a crash course on investing in small-cap stocks to get you ahead of the curve.

What Are Small-Cap Stocks?

Let’s first break down the phrase “small-cap.” The word “cap” is short for capitalization. It means the value of a company trading on a stock exchange.

But how do you arrive at this value? It’s simple.

Let’s say you have a basket of apples. Each apple costs $1.00 and there is a total of 20 of them. What’s the value of the basket? Multiply the unit price by the total number of apples and you arrive at $20.00.

The basket in my example is analogous to a company, and the apples to its shares.

Market Cap = Price of One Share × Total Number of Shares

You can now easily tell why a certain company has a small cap. Either its stock price is low or the company only has a small number of shares.

Any company with a market cap between $200.0 million and $2.0 billion is considered small-cap.

Difference Between Small-Cap Stocks and Penny Stocks

Don’t confuse small-cap stocks with penny stocks.

Penny stocks are shares that trade for roughly $10.00 or below. They usually have market caps below $200.0 million and may alternatively be called “micro-cap stocks.”

Some penny stocks may have market caps about as high as small-cap stocks, but their companies are lesser-known, less liquid, usually unprofitable, and therefore more risky.

Are Small-Cap Stocks Risky?

Of course small-cap stocks are risky. All investments are! Risk is an inescapable reality in the investment world. Even the textbook examples of supposedly risk-free securities only exist in theory.

Investors are often scared of small-cap stocks because of the perceived risk that these investments will go up in smoke, whereas large-cap stocks are more stable.

But here’s a reality check: the long-held “too big to fail” belief has turned out to be a fallacy. We have a history littered with such examples: Enron Corporation, WorldCom Group, Inc., and Lehman Brothers, to name a few.

It’s true, however, that if you were to rank riskiness, here’s what it would look like:

Large-cap stocks < Small-cap stocks < Micro-cap stocks

So yes, small-cap stocks are riskier than large-cap stocks, but their returns are also higher. “The higher the risk, the higher the reward,” is a doctrine in investing.

Take a look at the 10-year performance of the S&P 600—an index of 600 small-cap stocks—and compare it with the S&P 500, an index of 500 large-cap stocks.

The S&P 600 is in red and the S&P 500 is in black in the below chart.

Chart courtesy of StockCharts.com

The results are obvious: small-cap stocks clearly come out on top.

How to Invest in Small-Cap Stocks

Granted, not everyone is a qualified financial analyst. That’s why I like to keep things simple for my readers. You should be able to pick the best small-cap stocks on your own without having to learn all the financial mumbo-jumbo.

Here’s an easy test you can use to find the best small-cap stocks. It’s called the “Triple-E Test,” the three Es being equity, earnings, and excess cash.

These are the three fundamental items I check with any small-cap company. If the company is good on all three Es, it could be worth investing in.

• First is equity, which defines your investment in the company. If a company is delivering high returns on equity (ROE), it means your investment is multiplying. I like companies that generate ROE greater than 10%.
• Second is earnings. A company with consistent earnings usually has a durable advantage. If it has been consistently making money without much volatility in its earnings, we can forecast that the company will continue to do so for years to come (unless there’s an unforeseen disruption).
• Third is excess cash. A company with excess cash can manage to pay off its liabilities during a period of bad business. So look for companies that hold enough cash reserves in their bank accounts.

Any small-cap stock can be put to this test. If you’re finding it hard to shortlist a few, here’s a list of some popular small-cap stocks you can try the test on.

Small-Cap Stocks List

(Source: Google Finance, last accessed January 10, 2020.)

Should You Invest in Small-Cap Stocks?

Nearly every big fish of today was once a small fry. Investors who dropped their line at the right time and managed to catch the best fish are now enjoying delicious meals.

You too could catch a healthy fingerling today that could grow into a big fish tomorrow.

Like I’ve said before, it’s going to take skill—and maybe a bit of luck (but mostly skill).

My Triple-E Test could help you pick some safer small-cap plays for now until you become a more expert fisher.