Small Cap Stocks and Their Effect on the Economy

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

small cap companies
••• Small cap companies have the most potential for growth. 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.

These companies do 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. 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.

Small Cap Versus Large Cap and Mid Cap

Large-cap stocks have a capitalization of $5 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 $1 billion to $5 billion. A recent study showed they outperformed both small cap and large cap stocks over the last 20 years. That's because they grow more than large caps during the expansion phase but aren't as likely to go out of business in a contraction phase.

Small caps 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. That's because 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. That's because they need all their capital to grow. They are a better investment for those who don't need fixed income from their portfolio.

Since small-cap companies are less well-known, they are harder for an individual investor to research. 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 than you would with a large cap company.

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.

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.

Some small-cap companies are well known. 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.

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

  • Angie's List 
  • Smith & Wesson Holding Company
  • Sonic Corporation
  • Papa John's International

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. That's because small businesses contribute 65 percent 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 usually well past the initial start-up phase. That's because it has to be doing well enough to qualify for an initial public offering.

That 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.

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 ​a mid-cap or large-cap companies, they are less risky than investing in a business before it's gone public.