Small-cap stocks present attractive investment opportunities, and investors can research the potential growth of small-cap companies to evaluate if these are worth investing in. It’s important to consider the risks attached as small-cap stocks may have potential that is never achieved.
There are plenty of ways that you can analyse and separate stocks to help figure out which ones you might want to add to your portfolio next. One popular method is to look at market capitalisation rankings, which separate companies based on the total value of their outstanding shares.
There are three main rankings that are generally used:
- Small-cap
- Mid-cap
- Large-cap
Small-cap stocks are generally considered those that have a market capitalisation of $300m to $2bn. These companies tend to be younger and smaller than their mid-cap and large-cap counterparts.
Tip: It’s helpful to understand all of the capitalisation sizes — small-cap, mid-cap and large-cap stocks — so that you can make informed investing decisions.
What are the potential benefits and risks of small-caps?
While none of these factors are guaranteed to apply to all small-caps, they can be the reason why investing in these types of companies might work for you.
While there are potential benefits to investing in small-cap stocks, there are also some risks ranging from less liquidity to a higher chance of volatility. Again, while each of these might not apply to every small-cap stock, they could play a role in helping you make your decision.
- Small-caps could have more room to grow than mid-cap and large-cap stocks. Often, small-cap companies have not been around for as long as mid- and large-cap companies. Therefore, they may not yet have made their big breakthrough.
- You might not have to worry about the movements of larger corporate investors and brokers when looking to invest in the best small-cap stocks. Larger institutions and investors often do not focus on smaller companies. Therefore, they are less likely to take large “buy” or “sell” positions that could drastically alter the market.
- The potential lack of large institutional interest — combined with small-cap stocks often not having the same coverage and analysis as larger stocks — can mean buying prices remain lower.
- The liquidity of small-cap stocks refers to how difficult or easy it might be to sell them. The relative lack of interest or knowledge in them on the part of some investors and brokers can also be a negative, as it can be difficult to sell these stocks due to this lack of interest or knowledge.
- As many small-cap stocks are comparatively young in their business life cycle, they might not have as sturdy a foundation or the same cash flow as other businesses. With less stable footing, they may have less margin for error and less ability to navigate major events than larger companies.
- There is usually less analysis of small-cap companies than mid- and large-cap companies. For example, small-cap companies often will not have the same growth, or earnings reports or press releases. Therefore, you might have to do a lot of manual digging and maths to uncover potential investment opportunities.
Do small-caps offer dividends?
Yes, there are some small-cap stocks that offer dividends. Those that do can potentially offer two great benefits that investors must sometimes choose between when allocating their capital: the reliable payment of dividends and the aforementioned growth potential of small-cap stocks.
However, the number of small-cap stocks that pay dividends generally represents a small percentage of the total number of small-cap companies.
Some small-cap stocks that pay dividends include:
- Funds management business Magellan Financial Group Limited
- Outsourced administration service provider Link Administration Holdings Limited
- Firearms manufacturer Smith & Wesson
- Food company B&G Foods Inc.
Tip: While some small-cap stocks do offer dividends, it’s more likely that large-cap stocks will offer more reliable payments year after year.
How do you choose small-cap stocks?
When choosing a small-cap stock to invest in, you should consider the target growth of the company, as this will help you evaluate the stock’s cash flow. As you will see, some of these concepts overlap with other types of investment strategies.
Target growth
While this is something that many investors try to do across a range of strategies, it can be especially important when looking at small-caps. The potential for growth is one of the biggest potential benefits of small-cap stocks.
Look for companies that could offer a new service, provide an existing service better, or be set to take advantage of changing circumstances or regulations in their respective industry.
Put in the work
With generally less information and fewer traditional reports released, it often takes a bit of digging to unearth quality small-cap investing opportunities.
However, if you are willing to do your research — reading market news and analysis, staying up to date on small business news outlets and tracking company performance — you could put yourself in a better position to choose your next target.
Follow the money
Available cash and cash flow can be a good barometer for a small-cap company. It could mean that they have a better chance to weather some storms and also might show that they are in a good position to become cash positive sooner rather than later.
You can look at a variety of factors, including total asset value, price earning ratio (P/E ratio), and overall incomings and outgoings. Learning the fundamentals of research can help you to improve your investing decisions and better understand market upturns or downturns.
How have small-caps performed historically?
Some believe that the chance for larger growth margins means that small-caps often outperform large-caps. And, in general, small-cap stocks have outperformed large-cap stocks in the past. However, as with many aspects of investing, different events and market environments can change that.
On the ASX, following large economic downturns, many small-caps have bounced back better than their larger counterparts. Some say that reasons for this include more impactful recovery funding by the government and the wider range of industries and sectors found within the small-cap landscape.
For example, after the 2024 US elections when many global markets faced a sudden surge of volatility, small-caps stocks on the ASX, such as SHAPE and GWA Group, gained a six-star value during November 2024. There are also times when large-caps outperform their smaller counterparts though, as in the Dot-Com Bubble of the 1990s. However, small-cap companies started performing better once that bubble burst in 2000.
Final thoughts
As with other types of investments, small-caps come with a variety of benefits and risks. These comparatively small companies can be a great way to diversify your portfolio and could provide an entryway into a sector or industry at an agreeable price point.
Learn more about investing and build your knowledge on the eToro Academy.
FAQs
- What are different ways to analyse stocks?
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There are several different methods, but the most common methods are fundamental analysis (studying valuation and growth indicators) and technical analysis (using objective information to find patterns). You can also learn by studying management teams – their announcements, plans, and personal trading – and newsletters that cover advice on picking stocks.
- What is institutional interest?
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Institutional interest is, in contrast to individual traders and investors, very large companies, organisations, investment banks and so on that often trade shares in large parcels and high volumes. They provide liquidity to the market and often set the trends.
- What is a business lifecycle?
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Every business goes through a range of stages, defined variously as four, five or even seven stages. Forbes suggests the basic steps: start-up, growth, maturity, and either decline or renewal and rebirth.
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