What Are Small Cap Stocks and How to Invest in Them?

Small Cap StocksInvesting in Small Cap Stocks Made Easy

Small cap stocks are, metaphorically speaking, diamonds in the rough. If you find the right one and polish it up nice, it can sell for a fortune. But one wrong cut, and it will be rendered worthless. So finding the best small cap stocks is more skill than luck. But of course, some will have you believe otherwise.

It’s true that some have struck it rich overnight with a few lucky picks here and there. But let’s face the fact that nearly all of the bigwigs in the game have made it up there through skill and discipline. Just look at Warren Buffett—the billionaire investor who picked some rough diamonds early in the game with skill, not luck. Although, the latter may have played some part.

The truth is, small-cap stocks have historically performed better than their more famous counterparts—the large-cap stocks. I’ll get to that shortly. But here is the reason why that’s true.

If you start blowing into an already inflated balloon, it can only grow so much. Blow some more and it will burst. But partly inflated balloons have the capacity to fill up. Small-cap stocks are these partly inflated balloons that have room to grow, or in other words, add value.

Now, I understand that novice investors are boggled by questions. What are small cap stocks? Are they risky? Should I invest in them? How to find the best small cap stocks?

Worry not!

What ensues beyond here should serve as a quick crash course on Investing 101 to get you ahead of the curve.

What Are Small Cap Stocks?

Let’s first break down the phrase “small-cap” stocks. The word “cap” is short for capitalization. It simply means the value of the company trading on the stock exchange. But how do you arrive at this value? It’s simple.

Let’s say you have a basket of apples. Each apple costs $1.00 and there are a total of 20 apples in there. What’s the value of the basket? Simply multiply the unit price with the total number of apples and you arrive at a value of $20.00! That’s basic second grade math.

The basket in my example is analogous to a company, and the apples to its stocks. The price of this basket is the “market capitalization” or value of the company. Simply put:

Market Cap = Price of One Stock  x  Total Number of Stocks Afloat

You can easily tell now why these stocks have a small capitalization. That’s because either their price is cheap or only a small number of these stocks are afloat.

Finally, any company with a market capitalization of between $200.0 million to $2.0 billion is considered “small” cap. There you have it! Small-cap stocks! As easy as pie!

Difference Between Small Cap Stocks and Penny Stocks

Here’s quick trivia. Don’t confuse small cap stocks with penny stocks. The latter are the stocks that trade for roughly $5.00 or below. They usually have a market capitalization of under $200.0 million and may alternatively be called “micro-cap stocks.”

But some penny stocks may have market capitalizations as high as small-cap stocks. However, these companies are lesser-known, less liquid, usually unprofitable, and more risky.

But Are Small Cap Stocks Risky?

Of course they are! All investments are! Risk is an inescapable reality in the investment world. Even the textbook examples of supposedly “risk-free securities” only exist in theory. So if anyone tries to scare you of this boogeyman, you call their bluff.

The truth is, investors are usually scared of small cap stocks because of the perceived risk that these investments will go up in smoke. But here’s a reality check for you. The long-held “too big to fail” belief has also turned out to be a fallacy. We have a history littered with such examples—Enron Corporation, WorldCom Group, and Lehman Brothers Holding, Inc., to name a few.

It’s true that if you were to rank riskiness, here’s what it would look like:

Large-cap stocks < Small cap stocks < Penny stocks

So yes, small-cap stocks are riskier than large-cap stocks, but their returns are also higher. “The higher the risk, the higher the reward,” is a doctrine in investing. Take a look at the ten-year performance of the S&P SmallCap 600 Stock Index—a basket of 600 top small cap stocks—and compare it with the market index of 500 large cap stocks of the S&P 500.

The results are obvious. Small cap stocks clearly come out on top.

SLY stock chart

Chart courtesy of StockCharts.com

How to Invest in Small Cap Stocks?

Granted, not everyone is a qualified financial analyst here. That’s why I like to keep things simple for my readers. You should be able to pick the best small cap stocks on your own, without having to learn all the financial mumbo-jumbo.

I have formulated an easy test that you can use to filter out the best small cap stocks. If you’ve been following me, I’ve used it before to pick out small cap tech stocks.

I call it the “Triple-E Test”—the three Es being Equity, Earnings, and Excess cash.

These are the three fundamental items I check on any small-cap company before picking its stock. If a company checks on all three Es, it could be worth investing in.

First up is equity, which simply defines your investment in the company. If a company is delivering high returns on equity (ROE), it means your investment is multiplying. I like companies generating ROE greater than 10%.

Next, look for the second E—that is, earnings. A company with consistent earnings usually has a durable advantage. If a company has been consistently making money without much volatility in earnings, we can assume that it will continue to do so for the years to come, unless there’s an unforeseen disruption.

Finally, the last E is your insurance policy against those unforeseen disruptions. A company with excess cash can manage to pay off its liabilities through a period of bad business. So look for ones that hold enough cash reserves in their banks.

Now, any small-cap stock can be put to this test. But if you’re finding it hard to shortlist a few, here’s a list of some popular small cap stocks that you may want to run through the test.

Small Cap Stocks List

Small Cap Stock Market Cap                     

Business Focus

Ambarella Inc (NASDAQ:AMBA) $1.99 billion Action, drone, surveillance and car camera chip manufacturer
JinkoSolar Holding Co., Ltd. (NYSE:JKS) $554.09 million One of the world’s biggest solar companies
Sturm Ruger & Company Inc (NYSE:RGR) $1.07 billion Famous manufacturer of firearms
Boston Beer Company Inc (NYSE:SAM) $1.85 billion Well-known brewery
Solaredge Technologies Inc (NASDAQ:SEDG) $672.07 million Manufacturer of solar inverter batteries.

Should You Invest in Small Cap Stocks?

There is no reason not to!

Nearly every big fish of today was once the small fry. Investors who dropped the line at the right time and managed to catch the best ones are now enjoying their delicious meals. You too could catch a healthy fingerling today that could grow into a big fish tomorrow.

Like I’ve said before, it’s going to take skill and maybe a little bit of luck (but mostly skill). My Triple-E Test could help you pick some safer plays for now until you become a professional fisher.

You now have the skill. Here’s wishing you luck.

Good luck investing!