- October 31, 2017 at 11:57 am#52652smallcaptraderParticipant
Small cap stocks: More risk, more reward
Some of the most successful stock market investors in recent years have invested in shares of small cap companies. Famous investors like Warren Buffet and Peter Lynch have made fortunes from small cap companies because they see neglected, deep potential value before the market does. Numerous studies have shown that small cap stocks, over time, tend to outperform long term stocks, and by a wide margin – typically 2-3% more than their larger cap counterparts. These small gains can add up to substantial gains over time.
Larger investors don’t typically maintain their holdings in small cap companies, they have to skew their holdings to put more emphasis on larger cap stocks as their portfolio grows larger, and not focusing exclusively on small cap stocks. This can be an advantage for retail individual investors.
So why do small cap stocks historically produce larger gains than large cap stocks? The answer, basically, is that small cap stocks are riskier, according to several measures which we’ll touch on. But what exactly is considered a small cap stock?
A small-cap stock is generally one held to be valued at less than $1 billion. A stock with a market cap of less than $100 million is called a micro-cap, and a company with a market cap of less than $50 million is called a nano-cap. Should you invest in small cap stocks? Although small cap stocks have significantly more potential for larger gains, they also carry significantly more risk associated with them.
Small cap stocks can go through wide volatility swings, especially in declining markets, and most investors can’t stomach that kind of volatility and uncertainty. So investing in them is riskier, according to several measures:
Market Risk (beta)
Small cap stocks, and even more so with micro and nano cap companies, tend to be more volatile and have a higher level of market risk than large cap stocks. Market risk measures the risk of one stock investment against the market as a whole, for example, technology or biotechnology stocks generally will be more volatile than stocks in food or utility companies.
Also, small cap stocks also have higher market risk than large cap stocks because, generally, these firms are less established, have shakier financials, and often do not pay dividends.
A liquid asset is one that you can sell quickly, and at fair market value. Stock in small cap companies is often not liquid.
Small cap stocks can have a high liquidity risk because of their potentially small investor base, so it can be difficult trading into or out of a position in an asset with less trading volume. Many small cap stocks trade on less than 50,000 shares day.
Also, because of the lighter volume, it is harder for large institutional investors to buy or sell large amounts of the stock without significantly effecting the stock price.
Because small cap stocks get less coverage and are under-analyzed, there is also less market awareness for small cap companies. Because they get much less market coverage, they’re generally not followed by many analysts or financial reporters, therefore less coverage equates to less information available about small cap stocks.
Wall street firms have little incentive to follow small cap stocks because bankers who employ research analysts typically get paid a percentage of the size of the deals they work on, so bankers will put their research resources into larger sources of fees than smaller ones.
The risks mentioned, market risk, liquidity risk and information risk, might be a negative from some perspectives, but they can also be positive, because higher risk investments generally result in higher realized returns This is primarily why small cap stocks historically return two or three more percent a year than their larger cap counterparts. These small gains can add up to substantial gains over time.
Most fund managers are not aware of the 5000+ stocks in the US, and 50,000 globally, there are just too many companies to follow in detail. So how do you find companies off the radar from wall street? In my next article I’ll discuss ways to find and invest in small cap stocks.
- November 3, 2017 at 11:28 am#52668smallcaptraderParticipant
Where to Invest in Small Cap Stocks
Small-cap investing can offer excellent long-term investing possibilities. The easiest way to invest in small-cap stocks is through what is referred to as a “passive” strategy, and invest through an index fund or an exchange-traded fund (ETF), which is basically just a basket of small cap stocks. This strategy gives investors an opportunity to be active in the small cap market without having to do individual research to choose small stocks. Examples of a small cap index include the Russell 2000 ETF (IWM), SPDR S&P 600 Small Cap ETF (SLY), Vanguard Russell 2000 ETF (VTWO) and Vanguard Small Cap Index Fund (VB).
A passive strategy example could be to invest in a group of small, early stage firms in a fast growing industry, then eventually selling the laggards and adding to the winner, or winners.
Another method in choosing which small cap stocks to invest in is called an “aggressive” strategy, where you research and select your own small cap stocks. You can try to find companies that have a niche and that can dominate its field. Also, try to focus on deep value, a method used by Warren Buffett, which could eventually lead neglected stocks being realized by the market.
A famous quote by Peter Lynch says, “The average person is exposed to interesting local companies and products years before professionals.” An aggressive way of choosing which small cap companies to invest in is to find companies that have a niche, and that can dominate its market.
A good question to ask yourself when considering whether to invest in a small cap company, according to Peter Lynch, is “Can the company be replicated?”. A good example of replication is Starbucks, can its concept be replicated across the country, and is the company profitable?
But how do you find companies off the radar from wall street? You might be asking yourself, “haven’t all these good companies already been found?”. Believe it or not, most fund managers are not aware of the 5,000+ stocks in the U.S., and over 50,000 globally, because there are just too many companies to follow in great detail. If institutional ownership is less than 50%, then the stock is not widely followed by institutional mutual funds, hedge funds or pension funds.
But institutions tend to move in herds, so when one institution finds and invests in a good undiscovered small cap company, others follow which can quickly turn a small cap stock into a successful mid cap stock.
Many small and risky investments end up losing money, and many small cap companies end up going out of business. But those that turn out to be winners can sometimes return multiples on the initial investment. In baseball, a good hitter is one that can get a base hit in just 1 out of 3 plate at-bats. It’s the same way with trading or investing in small-cap stocks, you don’t need to bat a thousand to generate a winning long-term return. Nor do you always need to hit a home run. Putting a successful string of singles and doubles together can help to ensure your success as a small cap trader or investor.
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