Small-Cap Stocks and Their Effect on the Economy

Is Now a Good Time to Invest in America's Small Companies?

small cap companies
••• Photo: Thomas Barwick/Getty Images

Small-cap stocks are shares of ownership of small businesses. They have a market capitalization of between $300 million and $2 billion. The market cap is measured by the number of shares outstanding times the price of each stock.

Pros and Cons

Small-cap companies have greater growth potential. It's easier for them to grow because they have a smaller operational and financial base. Their small size also makes them riskier investments. They don't have the financial cushion to withstand crises or poor management.

Small-cap companies do especially well early in an economic recovery. That's because interest rates are still low. It gives them easy access to funds to invest in their growth.

On the other hand, they are also the riskiest stocks during an economic downturn. Smaller companies are more likely to fail in a recession. As a result, you should decrease your allocation of small-cap stocks when the business cycle enters the contraction phase.

Advantages
  • Growth potential

  • Do well with low interest rates

  • Easier to find underpriced stocks

Disadvantages
  • Do worse in a recession

  • Riskier

  • Time consuming to research

Small-caps aren't as well covered by the financial media as larger companies are. This provides both an advantage and a disadvantage. The upside is that there are more companies whose stocks are undervalued. Careful research can reveal which companies have been overlooked by other investors.

The downside is that it takes a lot of time to research small-cap companies. The information is not as widely available, so it takes longer to ferret out. You can still get information from the annual report and the internet. Unfortunately, there's less history. You will also have a harder time finding secondary news reports.

That's why many investors go with a small-cap mutual fund. They are run by specialists who are familiar with the qualities that make a small-cap company successful. It's usually much safer to invest this way than on your own.

Small-Cap Stocks Versus Penny Stocks

Penny stocks are a type of small-cap stock. Their share price is $5 or less, making them cheap to buy. They are often difficult to sell, according to the Securities and Exchange Commission (SEC).

The SEC warns you may lose your entire investment in penny stocks.

Penny stock companies are often not well known and there isn't a lot of information about them. That makes it difficult to determine their true share value. Most buyers aren't willing to take that risk.

Small-Cap Versus Large-Cap and Mid-Cap Stocks

Large-cap stocks have a capitalization of $10 billion or more. They are the least risky because their assets will see them through any downturn. 

Mid-cap companies have a capitalization of between $2 billion and $10 billion.  Mid-caps have outperformed small and large-caps over the last 10 years. That's because they are small enough to grow faster than large-caps during the expansion phase. Their size means they aren't as likely to go out of business as small-caps in a contraction phase.

Small-cap companies have an advantage over large-cap and mid-cap stocks during the expansion phase. The stock price will rise along with the company's growth. Large-cap stocks fall out of favor during the expansion phase. Investors who are chasing returns see them as stodgy and boring.

The peak phase of the business cycle is a good time to shift your allocation out of small-cap and into large-cap.

At that point, large-cap stocks will be relatively cheap. You will be glad you have them during the contraction phase. Even though the price of all stocks might plummet during a recession, small-caps might go out of business altogether. They don't have the resources to ride out an extended period of weak consumer demand.

Small-cap companies are less likely to pay dividends. They need all their capital to grow. They are a better investment for those who don't need fixed income from their portfolio.

Examples

You probably haven't heard of the names of most small-cap companies. Most of them are small finance, credit, or mortgage companies. You can see how they would have been risky to own during the 2008 financial crisis or the 2020 recession.

Please keep in mind that this is in no way a recommendation to buy. Rely on the wisdom of a financial planner before you buy any stock. Whether small-cap stocks fit your investment goals is always a personal decision.

Some small-cap companies are well known. Here's a list of some companies you might have heard of just to give you an idea of a small-cap corporation.

Company Symbol Market Cap Industry
Bed Bath & Beyond  BBBY  $1.1 B  Retail
Office Depot  ODP  $1.4 B  Retail
Tuesday Morning  TUES  $12.6 M  Retail
Groupon  GRPN  $741 M  Coupons

A financial planner will also tell you whether you're better off buying individual small-cap stocks or a small-cap mutual fund. 

Small-Cap Companies' Impact on the Economy

Small-cap companies are an important engine for job creation. Small businesses contribute 65% of all new job growth. That's why the federal government focuses on helping small businesses with loans and grants.

A small-cap company is typically well past the initial start-up phase. It has to be doing well enough to qualify for an initial public offering (IPO). Before a small business can issue an IPO, it must satisfy an investment bank that it is a well-run firm. Even though small-cap companies are riskier than ​mid-cap or large-cap companies, they are less risky than investing in a venture before it's gone public. 

An IPO takes a small business from the private equity phase to being a publicly owned company. At that point, its shares trade on the New York Stock Exchange or NASDAQ.

Article Sources

  1. Corporate Finance Institute. "Small-Cap Stock." Accessed June 4, 2020.

  2. Securities and Exchange Commission. "Important Information on Penny Stocks." Accessed June 4, 2020.

  3. Fidelity. "Understanding Market Capitalization." Accessed June 4, 2020.

  4. Yahoo! Finance. "Aggressive Small-Cap Stocks." Accessed June 4, 2020.

  5. Congressional Research Service. "Small Business Administration and Job Creation," Page 5, Table 3. Net Employment Change from Small Establishments, 2010-2018. Accessed June 4, 2020.