Small-cap stocks often show higher potential returns due to their innovative nature and ability to disrupt industries. For example, as measured by the Russell 2000 Index, small-cap stocks finished 2024 strong, with consecutive positive gains of about 3.4%.
The ability to deliver returns makes small-caps an attractive option for traders seeking growth in dynamic conditions. In this blog, we will talk about small-cap stocks in depth.
What is a small-cap stock?
A small-cap stock is a publicly traded company with small market capitalization. These are typically growth-stage companies, meaning they have the potential for high returns but may also come with increased risk. The risks may arise from their lack of financial strength and less market presence as compared to bigger companies (mid-cap companies or large-cap companies). Small-cap stocks are generally appealing to investors due to their growth potential, but they may also be more volatile, making them a riskier investment.
For example, small-cap stocks traded on the Australian Stock Exchange (ASX) are representative of companies with a market capitalization between a few hundred million to $2 billion. Similarly, a small-cap company in the United States is defined as one whose market capitalization is less than $2 billion. Traders must note that small-cap stocks' market cap can differ as per region.
Features of a small-cap stock
Market capitalization
Small-cap stocks have a market cap under $250 million in the US, as discussed above. These companies tend to be newer and less established. Their market cap size reflects their smaller presence in the market.
Higher growth potential
Small-cap stocks often show rapid growth potential. They may grow faster than large-cap stocks. Their size allows for quicker expansion. Hence, investors are attracted to their ability to generate large returns. However, this growth is not confirmed and depends on various market conditions and company strategies.
Higher risk and volatility
Small-cap stocks are highly volatile investments. They can experience sharp price fluctuations. This volatility results from their smaller market presence. Hence, investors need to tolerate significant market swings. Due to limited resources, market sentiment can impact their performance as they carry a higher risk compared to larger stocks.
Limited financial resources
Small-cap companies often have limited financial resources. Their access to capital may be constrained. Small cap companies always rely more on debt or small investor funds. Such limited resources can hinder business growth and stability. This makes them vulnerable during economic downturns as their financial flexibility is often restricted.
Innovation and new markets
Small-cap stocks often focus on innovation. They target emerging markets with high potential as these companies are more flexible and adaptable. They can quickly pivot to new ideas, and investors are drawn to such disruptive capabilities. This innovation can lead to strong growth opportunities in the future.
Lower liquidity
Small-cap stocks typically have lower liquidity. This is because fewer shares are traded compared to larger stocks. This makes trading the shares more difficult. Investors might face challenges in executing trades quickly. Lower liquidity can also lead to higher price swings and adds to the risk of investing in small caps.
Higher dividend yields
Some small-cap stocks offer higher dividend yields. They provide attractive returns to investors. However, these yields come with higher risks. Small-cap companies may not sustain high dividends long-term. Their financial stability determines the sustainability of these yields.
Pros and cons of trading a small-cap stock
Pros
- Lower competition: Fewer investors target small-cap stocks, offering more opportunities. Less competition can lead to higher returns.
- Opportunity for early investment: Investing early into a trend allows for high growth potential as small-caps expand into larger companies.
- Potential for market disruption: Small-cap stocks can disrupt industries with innovation, offering the chance for outsized returns.
- More room for expansion: Small-caps have greater growth potential and flexibility to scale quickly in new markets.
Cons
- Low institutional support: Lack of institutional backing limits growth and stability for small-cap stocks
Vulnerability to economic downturns: Small-cap stocks are more susceptible to economic recessions due to financial instability. - Limited analyst coverage: Small-caps often receive less analyst attention, leading to fewer insights for investors.
- Higher risk of failure: Many small-cap stocks fail due to competition and limited resources, increasing investment risk.
Small-cap stock investing strategies
Breakout strategy
Traders can watch for small-cap stocks breaking out of key resistance levels. When a stock moves above a price point where it has struggled to rise in the past, it may signal the start of an upward trend. Traders can enter when the breakout happens and set a stop-loss just below the breakout level to manage risk.
Momentum trading
Momentum traders focus on stocks that are moving strongly in one direction, driven by news or high trading volume. With small-cap stocks, this can be gainful during earnings reports or product launches. Traders enter when momentum is strong, using technical indicators like the RSI or moving averages to identify entry points, and exit when momentum begins to slow.
Swing trading
Swing trading aims to capitalize on price swings within a trend. Traders purchase small-cap stocks during short-term pullbacks within an overall uptrend and exit during price rallies. The strategy involves technical analysis to identify entry points at support levels and exit points at resistance levels. This allows traders to gain from the natural fluctuations in stock prices.
Value investing strategy
Value investors look for small-cap stocks that are undervalued relative to their intrinsic worth. By analyzing financials, growth potential, and market conditions, traders can identify stocks that are priced below their true value. The strategy involves purchasing these stocks and holding them long-term, anticipating that the market will eventually recognize their value.
Strategically incorporate small-cap stocks for portfolio growth
To incorporate small-cap stocks in the portfolio, start by allocating a small percentage to balance risk. Focus on thorough research and diversification to identify growth opportunities while managing potential volatility. Monitor the holdings regularly, adjust based on market conditions, and maintain a long-term perspective for maximum growth.
Disclaimer: All material published on our website is intended for informational purposes only and should not be considered personal advice or recommendation. As margin FX/CFDs are highly leveraged products, your gains and losses are magnified, and you could lose substantially more than your initial deposit. Investing in margin FX/CFDs does not give you any entitlements or rights to the underlying assets (e.g. the right to receive dividend payments). CFDs carry a high risk of investment loss.