Small cap stocks: More risk, more reward

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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.

Liquidity Risk

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.

Information Risk

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.

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"Why Invest in Small and Mid Cap Stocks" was originally printed in our stock trading forum, General Talk, at https://pennypicks.com/forums/forum/general-talk/. If you haven't done so already, join free to leave a comment, or start your own topic related to penny stock trading.




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