If you’ve ever thought that investing in the stock market was only for those who wanted to own tiny pieces of massive companies, think again. Small caps offer a route to investment that allows investors to take advantage of smaller company size in hopes of gaining larger profits from faster growth down the road.
What is a Small Cap?
Companies are grouped according to their market capitalisation, or the total worth of shares that are being traded on the market multiplied by their share price. For example, if a company only had three thousand shares being traded for a hundred dollars each, then its market capitalisation would be $300,000.
Small caps tend to have market capitalisations of under a billion dollars. To put this into perspective, in 2020 large companies like Apple have market capitalisations in the billions of dollars, while smaller firms, like the Australian company Netlinkz, may only have a market capitalisation of $100 million.
Advantages of Investing in Small Caps
By far the biggest advantage of investing in small caps is the fact that smaller companies tend to be capable of more explosive growth. The amount of money separating a small cap company from becoming a medium or even large cap is considerable, but given the right combination of growth, it is not insurmountable at all. Many large companies started out as small caps; the hype of tech companies going public and instantly having billions in market capitalisation is a relatively recent phenomenon, and is largely confined just to that sector.
Additionally, small cap investment allows an investor to get in on the ground floor. Small caps that are optimised for growth can quickly increase their share price and often split, resulting in even faster investment growth. Finally, for investors who want a voice, small caps are more sensitive to the advice of their investors.
Disadvantages of Investing in Small Caps
That is not to say that investing in small caps is without risks. Because they are smaller, they are less stable; Microsoft has tens of billions of dollars in collateral, but a small cap may have only a few million. Because of that lack of stability, small caps are not as able to secure financing on the terms that bigger companies would get, and this can result in more shares being sold, thus diluting an ownership interest.
Additionally, there’s less research out for any given small cap. Hundreds of analysts write about big companies, but there may only be a few filings available for small caps. Despite that, for an investor who is willing to put in the work, small caps can be a great way to add diversity and growth potential to a portfolio.
