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Small and Micro-Cap Stock Investing – Definition, Benefits & Risks

By Pat S

small cap stocks plantNowadays it seems like everyone has their favorite investing style. Nowhere is this more evident than Wall Street itself. Everywhere you turn, a different investment advisor or mutual fund is touting a new magic formula for market beating returns. Do they all deliver on their promises? Not even close. 66% of actively-traded funds fail to beat the market over any period in excess of 5 years, according to Time Magazine. When you factor in the expenses and sales loads of these advisors and mutual funds, it is safe to say that the percentage of the funds that fail to beat the market is even higher.

So what’s an investor to do? If the goal is for stable returns, there are two options. The first is to invest in low-cost index ETFs, which by keeping expenses low and mimicking market indexes, often outperform most mutual funds over time. This is likely the best and safest option for many investors. The second strategy is to invest in long-established, dividend-paying blue chip stocks with a history of increasing their dividend payout. These stocks generally provide steady returns while also exhibiting low volatility.

But what if you are an investor seeking significant market outperformance? Depending on your age, risk tolerance, and asset allocation, you may be seeking a stock or group of stocks with the potential for explosive returns. In that case, investing in index ETFs and blue chip stocks should only make up part of your portfolio. In addition, you should consider a commonly overlooked group of stocks that can offer this type of boost to your portfolio: small and micro-cap stocks.

What are Small and Micro-Cap Stocks?

Small and micro-cap stocks are stocks with small market capitalizations.

Generally speaking, publicly traded companies valued at less than $2 billion are considered small cap stocks, while companies with a value between $25 million and $300 million dollars are considered micro-cap stocks.

Benefits of Small and Micro-Cap Stock Investing

Small and micro-cap stock investing offers some real benefits to those investors seeking market outperformance.

1. Unlimited Growth Potential
Some of the best known companies in the world started out as small and micro-cap companies whose stock suffered as a result of the lack of coverage and visibility in the markets. Many of these companies have gone on to become the titans of Wall Street or to dominate their industry niche. Finding a company like this in its infancy is one of the greatest potential benefits to investing in small and micro-cap stocks. It only takes one small company growing into an industry leader to provide your portfolio with market-crushing returns.

2. Potential for Undervaluation
Everyone wants to invest like a young Warren Buffett and snap up companies when they are undervalued by the market. Based on the efficient market hypothesis, which states that stocks are always fairly valued by the market, this should theoretically be impossible. Luckily for you though, this is not the case in small and micro-cap investing. Because small and micro-cap companies are relatively unknown and generally have little or no equity research coverage, they can often be snapped up at a significant discount to their inherent value. Do your due diligence on the company, and you could have a huge leg up on other investors.

3. Prime Acquisition Targets
Just because small and micro-cap stocks are sometimes unknown by Wall Street traders doesn’t mean they aren’t being noticed by the leaders of their industries. In fact, many small and micro-cap stocks never do grow up into large multi-national corporations because they are eventually bought out by their larger competitors. As an investor, this is like hitting the jackpot because acquisition premiums can often offer many multiples of the company’s current stock price.

4. Long-Term Sustainability
Because the majority of small and micro-cap companies do not have the full attention of Wall Street, they don’t have to be as worried as their large cap counterparts about making long-term sacrifices to satisfy investors in the short-term. As a result, these companies are often focused on their long-term health and creating an efficient business that is sustainable and has significant growth potential.

5. Efficient, Focused Companies
Small and micro-cap companies have an extremely focused business model due to their size and, often, young age. Most of them have never made an acquisition and have not yet had the chance to expand the breadth of their business. Thus, small and micro-cap companies are focused and operate extremely efficiently. This characteristic is one reason they can serve as attractive acquisition targets; they boast industry expertise, and their focused business model makes them easier to be brought under the umbrella of a larger company.

Risks and Downsides of Small Cap Stock Investing

While small and micro-cap stocks seem like a sure thing if you find the right company, like any other investment in Wall Street, there are risks.

1. No Dividends
Because most small and micro-cap stocks are such fast growers, they generally retain all of their profits and reinvest them back into the growth of the company. While this is great for the future of the business, it also means that investors are left counting on capital appreciation as their sole source of potential upside.

2. Less Analyst Coverage
Let’s be honest. For most of us, a company balance sheet is pretty intimidating, and it’s often comforting to read an analyst’s report on a company’s potential before making any major investment decisions. With small and micro-cap stocks, this is often not the case. So, if you are going to go this route, make sure you can read a quarterly report and balance sheet without depending on heavy analyst coverage to indicate the overall health of the company.

3. Low Liquidity
While it isn’t usually the case for small cap companies, many micro-cap companies are extremely thinly traded. As a result, investors will have to deal with significant bid-ask spreads when trying to buy or sell the stock. It can also sometimes take days, weeks, or months to build up a significant position in the company due to this low liquidity. Generally, liquidity is not an issue with small cap stocks since there is enough coverage and interest in the company to foster a healthy trading environment.

4. Market Fluctuations
Mostly as a result of the liquidity issue, many of these smaller companies can be extremely volatile. Sometimes, all it takes is a buyer or seller trading a few hundred shares to move the stock price significantly. Be prepared for large movements both up and down, especially with micro-cap companies.

5. Prime Acquisition Targets
You’ll notice this point is also listed as a pro. This is because when you find a solid company with excellent growth prospects and a potential for future dominance in the marketplace, often the last thing you want is for that train to be derailed by a corporate takeover. Sure, you’ll get paid a pretty penny for your shares of stock in the short-term, but any long-term investor will likely feel a pang of sadness as their stock investment no longer offers the massive potential upside it once did.

Final Word

As you can see, small and micro-cap stock investing offers the potential for significant upside, and may be just the ticket to turbo-charging your portfolio for future growth. But before you start evaluating companies with market capitalizations below the $2 billion threshold, it is important to understand the risks of small cap stock investing as well.

For less advanced investors, small and micro-cap investing should make up a smaller portion of your portfolio due to the inherent risks and volatility. Also, be sure to do your due diligence before investing in any of these companies.

Have you invested in small or micro-cap companies? If so, do you have any additional pros or cons to add to the mix?

(photo credit: Shutterstock)

Pat S
Pat S is an active duty military officer. On his off time he enjoys working out, reading, writing and spending time with his dog. Pat became interested in personal finance after several costly mistakes early in his military career that could have been avoided by a basic understanding of personal finance.

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Comments

  • http://AAAMPblog.com AAAMPblog

    Small and Micro-Cap Stocks have another advantage pertinent to the current environment. They typically do well in times of increasing inflation. These companies are smaller and typically more nimble and able to adapt to a changing environment.
    Although you lose the small chance of picking the next Microsoft. I believe most investors should use ETFs to to invest in these stocks. Diversification provides so many benefits, particularly when these stocks should be a measured part of an investors asset allocation.
    Thanks for the informative article.
    Ken Faulkenberry

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