Small Cap Stocks: Everything You Need to Know

Small cap stocks have lagged behind the broader market in recent years. The Russell 2000 Index, which tracks the performance of small cap stocks, has underperformed the large-cap-dominated S&P 500 Index by a significant margin over the past decade. Small caps are currently trading at a discount to their historical valuations. Will they return to favor in the years ahead?

Now can be a good time to learn more about stocks of small capitalization, how to invest in them and determine if they have a place in your portfolio.  

What Are Small Cap Stocks? 

Small cap stocks are shares of companies with a market capitalization of between $300 million and $2 billion. Market capitalization is the total value of a company's outstanding shares, calculated by multiplying the share price by the number of shares outstanding. 

Small cap stocks are often seen as being riskier than large cap stocks, as they are less established and have less liquidity. However, they also have the potential to generate higher returns.  

Small Value vs Small Growth Stocks 

Small value stocks and small growth stocks are two types of small cap stocks. Here are the basics on how they work: 

• Small value stocks are companies that are considered to be undervalued, based on their financial metrics such as price-to-book ratio, price-to-earnings ratio and dividend yield. These stocks are often overlooked by investors, but they have the potential to generate high returns if they are able to meet or exceed expectations. 
• Small growth stocks are companies that are expected to grow their earnings at a faster rate than the broader market. These stocks are often priced at a premium, but they have the potential to generate even higher returns if they are able to achieve their growth targets. 

Examples of Top Small Cap Stocks 

For an example of small cap stocks, here is a brief description of the top five holdings in the iShares Russell 2000 ETF (IWM), one of the largest small cap exchange-traded funds, as of August 9, 2023: 

1. Super Micro Computer, Inc. (SMCI) is a leading manufacturer of server and storage systems for the data center and enterprise computing markets. The company's products are used by a variety of customers, including cloud service providers, financial institutions and government agencies. 
2. ChampionX Corp. (CHX) is a leading provider of products and services for the oil and gas industry. The company's products include corrosion control chemicals, specialty equipment, and services. ChampionX's customers are located in the United States, Canada, Europe and Asia.  
3. Chart Industries, Inc. (GTLS) is a leading manufacturer of cryogenic and compressed gas equipment for the industrial, energy and medical markets. The company's products are used in a variety of applications, including liquefied natural gas (LNG) production, cryogenic storage and medical gas delivery.  
4. Simpson Manufacturing Co Inc. (SSD) is a leading manufacturer of steel building components and metal products for the construction industry. The company's products are used in a variety of applications, including commercial and industrial buildings, schools and hospitals.  
5. Chord Energy Corp Ordinary Shares (CHRD) is an independent oil and gas exploration and production company. The company's operations are focused in the Permian Basin of West Texas and the Eagle Ford Shale of South Texas.  

Small Cap Stocks vs Midcap Stocks vs Large Cap Stocks 

Small cap stocks offer higher growth potential but come with increased risk and volatility compared to midcap stocks and large cap stocks. Large cap stocks provide stability and may be more suitable for investors seeking consistent performance and lower risk, while midcap stocks provide a balance between growth and risk.  

Here’s how small caps, midcaps and large caps differ in market capitalization: 

• Small cap stocks: Small cap stocks are issued by companies with relatively small market capitalizations. Market capitalization is defined differently by various market participants, but it generally falls within a range of around $300 million to $2 billion or sometimes higher. Small cap companies are smaller and less established in terms of size and market presence. 
• Midcap stocks: Midcap stocks represent companies with market capitalizations that fall between small cap and large cap stocks. Midcap companies typically have market capitalizations ranging from about $2 billion to $10 billion or even higher. 
• Large cap stocks: Large cap stocks, on the other hand, are issued by well-established companies with significant market capitalizations. There isn't a strict threshold, but large cap companies are often considered to have market capitalizations above $10 billion. Megacap stocks have market caps up to $1 trillion or higher. These companies tend to be industry leaders and have a well-established presence in their respective markets. 

Small Cap Stocks vs Penny Stocks 

Small cap stocks are generally more established and have a higher degree of transparency and regulation compared to penny stocks. Penny stocks typically have extremely low market capitalizations and low stock prices, often trading for a few dollars or even cents per share. There is no strict definition for penny stocks, but they are generally associated with very small or microcap companies.  

While both categories involve investing in smaller companies, small cap stocks offer a more reasonable level of risk and potential for growth, whereas penny stocks are associated with higher levels of speculation and risk. 

Pros & Cons of Investing in Small Cap Stocks 

Investing in small cap stocks can offer both opportunities and challenges. Here's a breakdown of the pros and cons associated with investing in small cap stocks: 

Pros 

• High growth potential: Small cap stocks have the potential for significant growth due to their smaller size and greater room for expansion. These companies can be in the early stages of their growth trajectory and may have innovative products, services or business models that can lead to rapid appreciation in stock prices. 
• Undervalued opportunities: Smaller companies may be overlooked or undervalued by institutional investors and analysts, creating opportunities for astute individual investors to identify hidden gems before they become widely recognized. 
• Less analyst coverage: While this can be a challenge, it can also be a benefit. With fewer analysts covering small cap stocks, individual investors who conduct thorough research may be able to gain a competitive edge and identify promising investment opportunities. 
• Mergers and acquisitions: Small cap stocks are often considered attractive acquisition targets for larger companies seeking to expand their market presence or access innovative technologies. 
• Diversification: Including small cap stocks in a diversified investment portfolio can help spread risk and enhance overall portfolio performance, especially when these stocks are not closely correlated with larger market trends. 
• Flexibility and agility: Smaller companies can often respond more quickly to changing market conditions and capitalize on emerging opportunities compared to larger, more bureaucratic organizations. 

Cons 

• Higher risk and volatility: Small cap stocks tend to be more volatile and sensitive to market fluctuations compared to larger, more established companies. This increased volatility can lead to larger price swings and potential losses. 
• Limited resources: Smaller companies may have limited financial resources, making them more vulnerable to economic downturns or unexpected challenges. This can impact their ability to weather adverse conditions and meet financial obligations. 
• Liquidity concerns: Small cap stocks may have lower trading volumes, leading to less liquidity in the market. This can result in wider bid/ask spreads and difficulty executing trades, especially for larger positions. 
• Less information and transparency: Smaller companies may provide less comprehensive and timely information to investors, making it challenging to fully understand their financial health and performance. 
• Higher failure rate: Small cap companies have a higher risk of failure compared to larger, more established firms. They may face difficulties in competing, gaining market share or attracting sufficient capital. 
• Limited track record: Many small cap companies are relatively new and may not have a long track record of consistent financial performance. This makes it harder to assess their stability and growth potential. 
• Market manipulation risk: Due to lower trading volumes, small cap stocks can be more susceptible to market manipulation and speculative trading. 

What Are the Small Cap Stock Indexes? 

There are several major small cap stock indexes that track the performance of small cap companies in the stock market. These indexes are used by investors, fund managers and analysts to gauge the performance of the small cap segment of the market.

Here are some of the most well-known small cap indexes: 

• Russell 2000 Index: The Russell 2000 Index is one of the most widely used benchmarks for tracking the performance of U.S. small cap stocks. It includes the 2,000 smallest companies within the Russell 3000 Index, which represents approximately 10% of the total market capitalization of the U.S. stock market. 
• S&P SmallCap 600 Index: The S&P SmallCap 600 Index is maintained by S&P Dow Jones Indices and includes 600 small cap companies chosen for their market capitalization, liquidity and industry group representation. It is a subset of the broader S&P 1500 Index. 
• Wilshire 4500 Completion Index: The Wilshire 4500 Completion Index is designed to measure the performance of U.S. equities outside the S&P 500 Index. It includes small cap, midcap and large cap stocks, with the small cap component representing the smaller companies. 
• CRSP U.S. Small Cap Index: The CRSP U.S. Small Cap Index is managed by the Center for Research in Security Prices (CRSP) and is used to track the performance of U.S. small cap stocks. It is part of the CRSP Indexes, which cover various segments of the U.S. stock market. 
• NASDAQ Composite Index: While the NASDAQ Composite Index is often associated with technology stocks, it also includes a significant number of small cap companies. The index tracks the performance of all companies listed on the NASDAQ stock exchange, including small cap stocks. 
• MSCI USA Small Cap Index: This index is part of the MSCI family of indexes and represents the performance of small cap stocks in the U.S. equity market. 
• Dow Jones U.S. Small-Cap Total Stock Market Index: This index is designed to measure the performance of small cap stocks in the U.S. stock market. It is part of the broader Dow Jones Total Stock Market Index. 

What Are the Different Ways to Invest in Small Cap Stocks? 

There are several ways to invest in small cap stocks, including individual stock purchases, mutual funds and exchange-traded funds. Each method has its own advantages, disadvantages and considerations.

Here are some different ways to invest in small cap stocks: 

Individual Stock Purchases 

• Directly buy shares of specific small cap companies through a brokerage account. 
• Allows for greater control and customization of your portfolio. 
• Requires research and due diligence to select individual stocks. 

Small Cap Stock Mutual Funds 

• Invest in mutual funds that focus on small cap stocks. 
• Provides instant diversification across a range of small cap companies. 
• Managed by professional fund managers who make investment decisions. 
• May have management fees higher than other types of funds like ETFs. 

Small Cap Stock ETFs 

• Invest in ETFs that track small cap stock indexes. 
• Offers diversification and trades like a stock on stock exchanges. 
• Generally has lower fees compared to mutual funds. 
• Provides exposure to the broader small cap market. 

Robo Advisors 

• Some robo advisors offer portfolios that include small cap stocks based on your risk tolerance and investment goals. 
• Provides automated portfolio management and rebalancing. 

Bottom Line: Outlook on Small Cap Stocks 

The market outlook for small cap stocks in 2023 is mixed. Some analysts believe that small cap stocks could outperform large cap stocks in the coming year, as they are often seen as being more undervalued and have more growth potential. Others believe that small cap stocks could underperform large cap stocks, as they are more sensitive to economic fluctuations and could be adversely affected by rising interest rates. 

Investing in small cap stocks can be rewarding, but it requires careful research, a strong understanding of the companies and industries involved, and a willingness to accept higher levels of risk. Many investors choose to include small cap stocks as part of a diversified investment strategy, blending them with larger cap stocks and other asset classes to manage risk while potentially benefiting from growth opportunities.