Why your Investment Portfolio needs Higher Exposure to Small-cap Stocks? Does it really?

Small cap stocks are always considered to be fraught with considerable risks, though they remain favorites among the retail trading fraternity. Those who follow financial media for investing related advice, often remain underinvested in small-caps as they are usually shown the negative side of investing in small caps. Everyday analysts call them risky, frequently fraudulent, and mostly poorly managed, certainly not something an investor would wish to invest in and hold for the long term. Then why should anyone consider investing in this space?

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Are Small-cap Stocks Really that Risky?

I must tell you that the size of a company is no good measure for predicting fraudulent practices, and many of us know that very well from our past instances with big names such as Enron. Many investors fall prey to internal fraud and lose substantial capital when companies decide to go against shareholders’ interest. So, the bottom-line is that investors should not refrain from small-cap stocks just for the sake of safeguarding their portfolio from fraud and bad management. Rather, one should explore the small cap universe and learn more about this exiting investment horizon. I bet there is much more money to be made than any place else, but don’t just dive in, read this post and find out how you can invest in this space with proper understanding and ample conviction.

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How to Identify Small-cap Stocks?

Small-Caps refer to stocks with a small market capitalization, approximately in the range of US$250 million and $2 billion; market capitalization keeps on changing so lookout for stocks on the borderlines. Stocks with a lower market cap, falling below $250 million are called Micro-Caps, while those below $50 million are called Nano-Caps. Small-cap stocks are tradable most of the exchanges, though a majority of them are listed on the Nasdaq or the OTCBB because of more lenient listing requirements.

It is vital that the difference between small caps and penny stocks is understood, because penny stocks are a totally different investment playground. Many small cap stocks today trade at a little more than $1 just like any penny stock, but the key difference is the liquidity that they enjoy over any average penny stock.

 

Really! Should you Re-consider Investing in Small-Cap Stocks?

Well, it all depends on your investment objectives and the amount of risk you are willing to take but there are many positive aspects of investing in small-cap stocks that outweigh their negative attributes.  Really want to know? Let’s dig them out

 

Much Higher Growth Potential

Successful large-cap companies do not enjoy their status from the very start, once they were all small businesses with modest beginnings. Small-caps give smart investors a chance at glory; if they pick the right stocks they could probably find the next Microsoft, Google or Apple, because at one point all of these companies were ignored small-caps. Hence, a smart well informed decision on your part could turn out to be a multi-bagger investment idea.

Another simple reason to invest in small-cap companies is that they are accompanied with a stronger growth rate unlike bigger players who enjoy market-cap of above $1billion and are mostly weighed down by their own enormity.

 

Individual investors’ advantage over Mutual Funds’ limitations

Mutual funds generally invest hundreds of millions of dollars in one company. However with small-caps this becomes an issue. Small-caps simply don’t have the market-cap to support huge investments. A fund manager will have to buy 20% or more of the company in order to make any difference in their funds performance. However, SEC has heavy restrictions on establishing stakes of this size. This gives individual investors a one up against mutual funds.

 

Taking Advantage of Lower Media Coverage

Usually, small-cap stocks are not on the radars of analysts’; with lesser media coverage small-caps remain under-reported or even undiscovered. So, there always remains a high probability for a smart investor to find under-priced small cap stocks before the world starts talking about them.

 

Small-cap investing isn’t anywhere close to safe-haven investing, so there are ample reasons why one should limit exposure to this space. You should know about these shortcomings –

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Key Risks with Small-cap Investing

• The money invested in small caps is exposed to a much higher degree of risk than that of certified cash-generating machines like Fixed Deposits, while talking about stock investments we may compare that to large-caps and blue-chips.

• A small-caps worth is calculated by its susceptibility to generate cash, but for this to happen it should be able to scale its business model. This is where the element of risk sneaks in. Not every company can replicate what companies like Apple, Microsoft and Google have done.
• Small-caps also face higher degrees of volatility, due to their size. It is quite common for a small cap to see fluctuations of 10% or more in a single trading day, this is something that does not go in-line with every individual profile.

• It takes serious efforts, good financial knowledge and plenty of time to unearth the next big thing. Working your mind with financial ratios, stock charts and growth rates isn’t easy. The entire math, may it be fundamental analysis or understanding the technical side of the small-cap story, must be done by you alone, which among other things is time consuming.

 

Conclusion

Small-caps do glitter on high growth, and early investors can make the most out of it, however, all this comes with much higher risks. So, if you are ready to for the risks then you can attempt to put your head into the small-cap sea where there are unlimited high growth stories. 

The best time to buy such stocks is when they are trading at historically low P/E ratios, and right now you can find many such companies some even trading half their book value. 

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