If you ask the average investor about small-cap stocks, there’s a good chance you’ll receive a negative recommendation. Small-cap stocks are often considered risky. Some even have a history of committing fraud. In general, there just isn’t the quality in a small-cap stock that an investor should expect when compared to popular large-cap options that are available in the market.
To an extent, there is some truth in the hesitation that investors have with small-cap stocks. There are more concerns. That means there are more risks. Yet when there are risks present, there are also greater rewards to be found.
Large-cap companies have their struggles as well. Internal fraud can destroy shareholder interests on any scale.
- In 1998, Waste Management reported $1.7 billion in fake earnings. That lead to a shareholder class-action suit that was settled for $457 million.
- In 2001, Enron shareholders lost $74 billion by keeping large debts off their balance sheets.
- In 2002, WorldCom inflated assets by up to $11 billion. Internal auditing by the company caught $3.8 billion in fraud.
Even government-backed institutions offer similar risks. In 2003, Freddie Mac misstated a total of $5 billion in earnings.
It is clear that the size of a company or the industry where it operates cannot be the only factors to consider for investors.
What Are the Risks of Investing into Small-Cap Stocks?
There are 5 equity categories available, based on market capitalization, and micro-caps are the only investment option that are riskier than small-cap stocks. That is because the value of the stock is often based on the company’s ability to generate cash.
To generate cash, the company must have scalability. That is where the primary risk for an investor takes place. Smaller companies have limited demographic targets, small balance sheets, and geographic limitations.
Small-cap stocks are also more sensitive to volatility within the market because of their size. It is easier to move prices with these stocks because it takes less volume to do so. The average small-cap stock may fluctuate in pricing by 5% or more on individual trading days.
It can also take a lot of time to uncover the hidden gems within the world of small-cap stocks. It requires authentic and lengthy research to determine if growth rates, financial ratios, and reporting are moving in a positive direction. It is a process that most investors must do on their own, which means beginning investors who do get involved may guess at stocks or take advice from others, for better or worse.
Most small-cap companies have very little public information to base investment decisions on as well. Quarterly earnings must be released. Anything beyond those reports can be difficult for any investor to find, much less someone in the market casually.
What Are the Rewards of Investing in Small-Cap Stocks?
The primary reason to invest in small-cap stocks is their large potential for growth. Just above every large-cap company in the market today started as a small-cap stock. Even a company like Walmart, which was once a small local store in Arkansas, had humble market beginnings.
With small-cap stocks, there is the potential of finding the next Netflix, Microsoft, Apple.
Most mutual funds will not invest in small-cap stocks, which means investors have more room to operate. That also means many smaller caps tend to be under-recognized and undervalued. There is a high probability, right now, that there are small-cap stocks which are improperly priced and within your investment range which could expand the profit potential of your portfolio.
Here’s an example.
If you were lucky enough to be involved with one of these companies from the very beginning, it wouldn’t have taken a large investment to create a lot of value within your portfolio. If $100 had been invested into Apple in 2002, it would have a total value of more than $6,500 right now.
Instead of looking back in hindsight at what could have been, investors must be out there right now, sifting through numbers, to find the next opportunity. Being successful with small-cap stocks doesn’t make one investor smarter or more special than another. It just means that they have found options with the lowest risks and the highest possible return opportunities on their investment.
Large-cap companies operate in a mature market space, which means their opportunities for organic growth are limited. They offer conservative returns and a reasonably safe harbor for investors to maintain their portfolio. That is why real growth comes from small-cap stocks.