Understanding Small-Cap Stocks

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Updated on Wednesday, February 13, 2019

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Stocks come in a variety of sizes. They are differentiated by their market capitalization, which refers to a stock’s market value times the number of its shares that are outstanding.

Many large-cap stocks are household names. Some examples include Apple, Facebook, Johnson & Johnson, Pfizer and Amazon. The S&P 500 and the Dow Jones Industrial Average are two popular large-cap stock benchmarks that are widely followed by investors and the financial news media.

Meanwhile, small-cap stocks have a smaller market cap and tend to be less well-known. Here, we’ll describe what a small-cap stock is and what it refers to as well as some risks that you’ll want to keep in mind before investing.

Defining market cap levels

  • Large-cap stocks typically are defined as those with a market capitalization of $10 billion or more.
  • Mid-cap stocks generally are defined as those with a market capitalization in the range of $2 billion to $10 billion.
  • Small-cap stocks typically are defined as those with a market capitalization of less than $2 billion, with the smallest of the small caps (generally with a market capitalization of $50 million to $300 million) known as micro-cap stocks.

As an example, let’s take a hypothetical small-cap stock that we will call ABC Company. ABC’s current stock price is $10 per share, and it has 145,000,000 shares of its stock outstanding. This would equate to a market cap of $1.45 billion.

What major indexes track small-cap stocks?

There are several stock market indexes that track small-cap stocks.

The Russell 2000 is a widely followed index that encompasses the 2,000 smallest stocks by market capitalization, while the Russell 3000 comprises the 3,000 largest stocks in the U.S. market. These indexes are weighted by the total shares of the constituent companies represented, meaning that both total shares and share price influence the level of the index.

The Russell 2000 is the benchmark for many small-cap mutual funds and exchange-traded funds (ETFs) in much the same way that the S&P 500 is for many large-cap funds.

Another widely used small-cap benchmark is the S&P SmallCap 600. As the name implies, there are only 600 stocks in this index, and these stocks are weighted based on their relative market capitalization. That means certain stocks can have an outsize influence on the direction of the index in both up and down markets.

Why invest in small-cap stocks?

Small-cap stocks can offer several advantages for investors:

  • The companies behind small-cap stocks are small. If a company’s product or service becomes a hit in its marketplace, it can experience outsize growth. Apple was once a small-cap stock, for example.
  • Small-cap stocks often are not widely followed by Wall Street. Although it’s not always easy, investors who can discover and invest in solid small-cap stocks can be rewarded if the underlying company experiences growth. The small size allows for room to grow if the company is successful.
  • Small caps can offer a level of diversification in a portfolio heavily concentrated in large-cap stocks.Small caps will outperform in some time periods and underperform large caps in others.

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Risks of small-cap investing

Small-cap stocks also can present several risks for investors:

  • The companies behind small-cap stocks often have one or a limited line of products or services. If a company hits a snag in its business, that could be catastrophic for the company. This differs from many larger companies that offer a greater number of product or service lines and may have a number of business units in diverse areas.
  • The financial structure of small companies may not provide a financial cushion during periods of financial stress. These companies might have smaller balance sheets than their larger counterparts and less access to capital to allow the company to grow.
  • Small-cap stocks may offer investors less liquidity than large-cap stocks. Shares of companies like IBM, Exxon Mobil and other large caps are widely traded, and investors rarely have to worry about liquidity when looking to sell. This might not be the case with some small caps whose stocks are not widely traded. When an investor looks to sell, there must be a willing buyer on the other end of the transaction — which might not always be the case with small caps. This could result in a wider spread between the price the seller is looking for and what they actually receive.

Investing in small caps using funds and ETFs

Investing directly in small-cap stocks can offer much upside and the potential for growth if you are able to pick the right stocks to invest in.

Another way to tap into small-cap stocks is by investing in small-cap mutual funds and ETFs. There are any number of small-cap funds available to investors. Some funds are actively managed, meaning the fund manager actively holds small-cap stocks they feel will outperform based on their research and other criteria.

There are also passively managed small-cap mutual funds and ETFs that track benchmarks like the Russell 2000 index.

Two examples of popular small-cap index ETFs include:

  • iShares Russell 2000 ETF (IWM): This ETF tracks the Russell 2000 index.
  • SPDR S&P 600 Small-Cap ETF (SLY): This ETF tracks the S&P 600 index.

Beyond these choices, a wide range of mutual funds and ETFs track small-cap value and small-cap growth stocks, and a number track small-cap blend (a mix of growth and value) stocks.

The advantage of using a managed approach like a mutual fund or ETF is getting professional management that eliminates the need to research and track individual stocks. The disadvantage here, though, would be missing out on the “next Apple.”

Bottom line

Small-cap stocks can be a solid addition to any portfolio. Managed portfolios like mutual funds and ETFs can provide investors with professionally managed vehicles for this asset class. Picking individual small-cap stocks can offer the opportunity for substantial gains but can carry some additional risks that the average investor may want to avoid.

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