The draw of small-cap stocks – their potential for outsized returns – is elusive and universally appealing across investor types.
If you’ve heard the term before, and find yourself interested in learning more about these kinds of stocks and how to invest in them, you’ve landed on the right page.
What follows are our four easy steps simplifying the process of small-cap investing.
Market capitalization
We’ll begin by breaking down the “cap” in “small cap,” which stands for market capitalization. This term refers to a company valuation metric attained by multiplying total shares outstanding by current share price. The result is the total dollar value of a company’s shares as determined by the stock market.
Market cap is useful for investors as a quick way of estimating a company’s value, which can serve as an initial impetus toward further due diligence. It also allows us to categorize companies by size, from micro caps to large caps, each of which carries different associated risks:
Micro-capstocks (less than $250 million) tend to exhibit higher volatility because of unproven businesses, limited histories and information and minimal trading, all of which leads to wider bid/ask spreads. During bull markets, these companies have a higher chance of outperforming broad indices thanks to their high volatility and growth potential. Total capital losses and annual returns over 100 per cent are common outcomes.
Small-cap stocks ($250 million to $2 billion) may also operate businesses in their infancy, as well as serve niche or emerging industries, with an operational track record to justify a more substantive investor base, market cap, and sense of conviction in long-term growth. Outsized returns and significant losses remain a possibility with small caps contingent on value creation and their offerings attaining wider market recognition.
Mid-cap stocks ($2 billion to $10 billion) are generally expanding companies beginning to attract institutional investors because of a clear trend of rising profits and/or market share.
Large cap or blue-chip stocks ($10 billion to $200 billion+) represent the lowest-risk investments, in terms of market cap, because of their established histories as key players in their respective industries. Growth within large caps is more limited, because most of it has already occurred, which is why investors tend to allocate to them for steady long-term share and dividend appreciation. Large caps also make up the majority of broad market index funds, which provide stock price support thanks to index investors’ regular contributions.
With our market cap landscape in place, we can now begin to narrow down your potential smaller-cap investments.
Source: Lemonsoup14.
Step one: Brainstorm investment goals
First, let us consider how small and micro-cap stocks fit within your investment goals, which may be short, medium or long-term in nature.
Short-term goals up to three years, such as saving for a vacation or major appliance, are best suited for cash or short-term debt instruments such as bond funds or guaranteed investment certificates. Unlike stocks, these investments will likely suffer little to no losses, shielding you from a drop in savings as you reach your target dollar amount.
Medium-term goals between three and five years, including saving for a car or a down payment on a house, can admit a mix between cash and bonds and limited equity exposure. Any stocks in this case would have to have clear growth catalysts over your holding period. You should also understand how the stocks’ prices have fluctuated over time and make sure you can tolerate this risk.
Finally, long-term goals over five years, such as paying for college or a retirement nest egg, are where micro and small-cap stocks are best positioned to shine. This is because these businesses tend to require long time horizons to grow into their upside potential and build lasting market presences. While there will likely be volatility on the way to goal-enabling returns, you have the benefit of many years or decades for growth to compound before selling an investment.
An alternative option for any goal horizon is short-term stock trading, where gains are made from studying and predicting a stock’s fluctuations over weeks, days and even minutes using charts and graphs. This strategy is high-risk given the high correlation between success and a trader’s expertise, but can prove incredibly lucrative for a chosen few. See step four for a selection of platforms to add to your stock analysis toolbox.
Step two: Research and due diligence
As we’ve discussed, smaller-cap stocks tend to be higher-risk, high-reward investments because many of the underlying businesses are only beginning to establish their value propositions for investors. This is why it’s important to compile as much information as possible about these stocks to justify their ability to meet your investment goals.
A website like Stockhouse can help, as it allows investors to research stocks – with an emphasis on micro and small-cap stocks – through access to recent company news, financials, valuation metrics and peer-to-peer comparisons.
Investors can also learn about companies through expert opinion and analysis, as well as world-class tracking tools, and discuss them in Stockhouse’s Bullboard section with a community of more than 1 million unique visitors per month.
The site provides insights that will not only help you make sound allocation decisions toward funding your financial goals, but also guide you through the moody nature of markets so you can sleep well and stay invested during bearish periods.
Step three: Find a small-cap investment vehicle
Once the research is done, the next step is purchasing shares.
Large financial firms like Canaccord Genuity, Raymond James or the well-known Goldman Sachs do not invest in micro or small-cap stocks.
The same goes for the wealth management arms of Canadian banks such as TD, CIBC and RBC.
This is predominantly because of the mismatch in size between these firms and smaller-cap issuers. To achieve meaningful profits, the firms would have to take controlling positions in these issuers, which would entail management headaches beyond their normal lines of business. To avoid this issue, large institutions focus mostly on mid- and large-cap stocks.
This is why, if you decide to buy smaller caps, you will likely do so by managing your own investments, with the added benefit of potential buy-ins by larger firms should your picks grow over time. For this, a variety of platforms are available to help you navigate the process – such as Qtrade, Questrade and WealthSimple– which offer numerous accounts to buy and sell individual stocks, or baskets of stocks in mutual funds and ETFs.
Step four: Monitoring and rebalancing small-cap investments
Now that your smaller-cap investments passed your due diligence process and are sitting snugly in your portfolio, you will need to periodically monitor and rebalance them to optimize their performance.
When a portfolio is unbalanced, it holds too much or too little in a given company, sector, industry or geography for an investor’s goals and the level of risk vs. reward they’re willing to tolerate. This can be rectified by purchasing underrepresented investments with cash on hand or by selling a portion of outperformers.
Someone with a portfolio of 100 per cent small-cap stocks may be adequately invested, supposing they have lots of cash in the bank to cover expenses and weather the volatility long into the future, while another person, perhaps with many dependents, may find themselves lacking much-needed funds during a market downturn, wishing they hadn’t gotten rid of their cash and bonds.
The key is to follow our four steps and tailor a portfolio that suits your needs, knowledge and abilities, so you can stick with it and bankroll the life you deserve. Whether that means 80 per cent stocks/20 per cent bonds, 50 per cent stocks/50 per cent cash, or some other variation, give yourself time and room to adjust until you find the right mix.
Once that mix is in place, and you set your rebalancing period – annually or bi-annually being the most common – you can focus on monitoring your investments based on market conditions to capitalize on undervaluation, trim when prices are rich, and ultimately sell to make the elements of step one a reality.
Many online platforms facilitate this monitoring process through training and easy-to-use interfaces for reading stock charts and forecasting trends. Here are a few options to get you started:
As you become more knowledgeable about smaller-cap stocks, you will grow more confident with identifying prospective picks, taking advantage of their volatility and buying more shares when they’re out of favour, setting yourself up for maximized long-term returns.
Your future self will be grateful for the windfall.
The material provided in this article is for information only and should not be treated as investment advice. For full disclaimer information, please click here.