The so-called small-cap stocks refer to listed stocks with a small market capitalization.
Much higher chance of becoming a 10-bagger
In my recent book, I have discussed the advantages and disadvantages of small stocks. In the book “The Rules of 10 Baggers“:
- Section 6-3, pp. 286-289, Discussion on companies with high market capitalization and high stock price may still become 10 baggers in the future
There is a sentence in my book: “If the market value of a company is too large, the possibility of becoming a 10 baggers or a 100 baggers in the short term is indeed relatively low in terms of probability.” This sentence is similar to the one in my book. Numerous examples and data have proved that the probability of small stocks becoming 10 times or 100 times stocks in the future is much higher than that of medium or large stocks.
Pros and cons
“Roughly speaking,” small-cap strengths are almost as bad as they are.
The Pros of Small-Caps
The value of small-cap stocks is small. As long as there is any bullishness, the rise will be fierce. This is the most fascinating part of small-cap stocks.
If it is a small-cap stock that has just been listed, the business field will be relatively new or a popular industry that is sought after by investors. The future market is large; of course, the probability of potential stock price rise is relatively large. Not a newer field or a questionable business model, and the stock exchange is less likely to take it public, because there may be no one to buy the stock, and the IPO will not succeed at all. Wework, a company known as a shared space unicorn, failed to go public and even went bankrupt because of it, which is a typical example.
Because of the small market capitalization of small-cap stocks, as long as the companies do not perform too poorly, even if they are in an operational crisis, there will be companies willing to take over at any time. Especially for popular listed companies, the premium offered by the acquirer will be dozens of percentages higher than the closing price of the day before the public announcement; some bids can even be several times the market value.
The Cons of Small-Caps
Small-cap stocks are small in value and their stock prices fluctuate greatly. For conservative investors, it is recommended not to hold them.
Small-cap companies have very small revenues, and their business operations are very single and not diversified enough. Therefore, it is difficult to resist the economic downturn, or the loss of any major customer, or the supervision of government laws and regulations, which will cause a fatal stock price drop.
Most small-cap companies are loss-making companies. Investors don’t care much during the bull market, but as long as the interest rate rises (for example, starting in 2021), they will be severely hit and even go bankrupt due to insufficient operating cash flow.
Small-cap stocks, not all, but many of them are newly listed stocks that have not yet been reviewed for a long time, so investing in them is risky.
Small-cap stocks are small in value, usually with concentrated ownership, and are easily manipulated.
Keep yourself away from OTC small cap
Small-cap stocks are small in value, usually with concentrated ownership, and are easily manipulated. Especially for small-cap stocks listed on OTC, unless investors have “very, very special” reasons, my suggestion is to stay away from them and never touch them. As for the reason, please refer to Section 2-1, pages 064-069 of my recently published book “The Rules of 10 Baggers” for a detailed discussion on OTC. In short, the two characteristics of OTC plus small stocks will be fatal to average retail investors.
Wall Street’s Attitude To Small-Caps
Wall Street Has No Interest in Small Caps
Wall Street is not interested in small caps for a number of reasons. Unless you have a very specific reason, don’t track small caps. Because of this, no professionals will conduct an in-depth analysis, and there is very little information about small-cap stocks, and it is even more impossible for financial media to report it.
Institutional investors are not interested in it either
Institutional investors, including pension funds and stock funds, are usually highly correlated with Wall Street’s attitude towards stocks, because except for a few industry analysts who have their own (even if there are, the number cannot be too many), institutional investors usually rely heavily on Wall Street analysis professional opinion of the teacher.
Moreover, large institutional investors are limited by regulations, and the possibility of large institutional investors’ investment in small stocks is very low. For details, please refer to my previous articles “The disadvantage of retail investors” and “The advantages of retail investors“.
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Strategies for Active Investors
Small-Caps Deserve a Place in Your Portfolio
You can find a company’s total valuation, or market capitalization, by multiplying the company’s stock price by the number of shares it has outstanding. For example, if a company has a stock price of $100 and 1 million shares outstanding, it has a market capitalization of $100 million. In terms of size, companies fall into three categories: small-cap, mid-cap, and large-cap.
Small-caps have a market capitalization between $300 million and $2 billion, mid-cap companies have a market capitalization of $2 billion to $10 billion, and large companies have a market cap of more than $10 billion. Investing in small-cap stocks is riskier, leading some to wonder whether to invest in them. Simply put, the answer is yes.
Give your asset a chance to grow at a high speed
Due to their size and financial resources, large caps tend to be more stable and reliable than small caps. Weathering nasty economic storms is a lot easier when you have billions in cash on hand. However, the size of large companies also limits some of their growth potential. Small caps are the opposite. Their size gives them more room to grow, but since smaller size generally means fewer resources, they are more volatile and vulnerable to more economic conditions.
To truly have a diversified portfolio, you have to invest in companies of all sizes. If you don’t, you could be hurting yourself and missing out on great companies with huge potential. Take Amazon (US stock code: AMZN), the world’s fifth largest listed company with a market capitalization of more than $900 billion, as an example. It was once a small-cap stock with an initial public offering (IPO) valuation of about $438 million. Apple (APL: AAPL), the world’s most valuable public company, was also a small cap before and after its IPO.
Amazon and Apple are certainly once-in-a-lifetime companies that shouldn’t be considered the norm, but if you never invest, you’ll never give yourself the opportunity to earn returns like this.
The most conservative approach
Get ready for a stock market rally
Small-cap stocks typically suffer during bear markets, as investors flock to larger companies for the stability they can provide. Conversely, small-cap stocks tend to have more upside early in a bull market; during a bull market, stock prices typically rise faster than they fall during a bear market, as investors rush to put more money into stocks to take advantage. This favors small caps.
During the crash, the Russell 2000 fell more than 46% from September 2008 to March 2009; but since then it has gained more than 380%. In the early stages of the 2020 COVID-19 pandemic, it fell nearly 40% from February to March; since then, it has risen more than 86%.
Rather than letting this downturn in the stock market deter you from investing in small caps, think of it as an opportunity to acquire some great companies at a “discount” and position yourself for future gains. You don’t want the majority of your portfolio to be small caps, but around 10% is a good benchmark.
Small-Cap ETF
Since the risk of small-cap stocks is indeed higher, if you are an extremely conservative investor, but want to have the explosive potential of small-cap stocks. One way to reduce risk is to invest in a broad small-cap index fund similar to the Russell 2000. The Russell 2000 Index tracks the smallest 2,000 companies in the Russell 3000 Index, which is considered the primary benchmark for small-cap stocks. In contrast, the S&P 500 is made up of large-cap stocks.
The best index fund on the market that tracks the Russell 2000 is the Vanguard Russell 2000 ETF (VTWO) because it has a low holding fee of just 0.10%. The constituents of the Vanguard Russell 2000 ETF include 1,970 companies in all 11 major industries. The industries covered and the percentages are as follows:
- Basic Materials (4.00%)
- Consumer Discretionary (12.50%)
- Consumer Staples (3.20%)
- Energy (7.30%)
- Finance (17.60%)
- Healthcare (16.40%)
- Industrial (16.60%)
- Real Estate (6.40%)
- Technology (10.40%)
- Telecommunications (1.90%)
- Utilities (3.70%)
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