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Small Cap Stocks: Investing in Growing Companies

Small Cap Stock Investing vs. Fishing

Investing in small cap stocks is kind of like fishing…

It’s easy to go out to your local fish store and simply buy fish. Anyone can do that.

What most people can’t or won’t do is set out on the open waves of the ocean and do some actual fishing. But it just so happens, that’s where the freshest fish are caught.

“Umm… excuse me Wall Street Survivor. I didn’t come here to learn about fishing.”

Oh, but you did. See, small cap investing is a lot like heading out into the unpredictable and treacherous waters of the ocean. Albeit a little dryer.

Small cap investing involves a good amount of risk. You’re putting your money into relatively small companies, often with uncertain futures. But, just like the big taste you’d get from that ocean-caught fish, these early-stage companies could lead to big returns.

And I’m still not done justifying this analogy:

Most people will head out to a popular market or grocery store to buy their fish, because they know what they’re getting. Same goes for stocks. Most investors put their money in big, stable companies because they’ve got a better handle on the potential returns they’ll receive.

But if you’ve got what it takes to handle the deep-sea waters of small-cap trading, then you’ve come to the right place.

As the saying goes: “Give a man a fish and you feed him for a day. Teach a man to fish and you feed him for a lifetime.”

So, let’s go fishing…

Market Capitalization

Before we go any further, we all have to understand one key concept: market capitalization (or market cap).

Here’s a WSS video that explains market cap quite simply:

For all of you who are slacking at work to take this Course (we call that “productive procrastination”) and can’t watch a video right now, here’s the long and short of it:

Market cap is a company’s current market value. It is the total number of shares in the market, multiplied by the stock’s current price.

Companies considered ‘small cap’ are generally those with a market cap between $300 million and $2 billion. Now to most of you, that probably doesn’t sound very “small”. But for publicly traded companies, it is. I mean, just look at Apple’s market cap ($1.15 trillion)!

The Allure of Small Cap Stocks

Ok, we get that small cap investing involves companies with small market caps. But why would one want to invest in small cap stocks?

Great question. Here’s why:

  1. High risk = high reward: As we said, small cap companies are risky. That’s because they have a less-established history of success. A longstanding behemoth like Proctor & Gamble is a much more stable investment than a company with a few hundred million dollars in value. But it’s that potential for growth – if that small cap stock can one day become a behemoth like P&G – that gives the allure for high possible return.
  2. Less attention = lower price: Stock prices are not only affected by the company’s business, but also by investors’ behavior. That means that very popular, large-cap stocks will often have inflated prices since everyone’s paying attention to them. Small cap stocks tend to have less attention on them because: a) investors stay away from their riskiness and b) institutional investors (like mutual funds) have restrictions when it comes to investing in small cap companies. There are fewer eyes on these stocks, making for smaller price tags.
  3. Getting in early = coming out on top: Many small cap stocks will go unnoticed, and rightfully so. Others are gold mines waiting to be discovered. It all depends on the company itself. But when a low-priced stock shoots up in value because it just made its mark, early investors can see the value of their shares soar.

Investing in Small Cap Stocks

So, you like what you hear. And you want to get involved. Awesome…but first, you have to know what you’re doing.

Here are some things to consider when getting involved in small cap investing:

Diversify: As we covered in the Basics of Diversification, diversifying your portfolio with different sized companies allows you to reduce your exposure to unsystematic risk. So if the possible gains of small cap investing are making it hard to resist, make sure to complement those small cap stocks with some big, reputable companies in your portfolio.

Ignore the Hype: Small cap success stories are great entertainment, but don’t rush home and buy everything you hear about. Small cap companies come with a fair amount of uncertainty. Knowing more than other investors about the product and business gives you a huge leg up on picking winners. So, shut out the noise and do your own research.

Know the Ropes: Speaking of research, let’s take a look at how you can follow small caps stock and keep yourself informed. A great way to get involved in this area of investing is by following the small cap market as a whole. You can do this by following small cap market indexes.

A great place to start is with The S&P SmallCap 600. You’ve probably heard of the S&P 500, which follows 500 stocks that represent the entire stock market. Well this index zooms in a little, following 600 small cap stocks meant to represent the small cap segment of the market. In the past 5 years, the average yearly return on this index has been just under 10%. This shows us how the small caps market has been doing and can help you decide whether it’s time to get involved or not.