Small cap is a term used to identify company stocks with a relatively low market capitalisation, or the tradeable value of its outstanding shares. The definition of small cap varies among investors, but it is generally considered to be a company with a market capitalisation of less than $2 billion. To calculate a company’s market capitalisation, multiply its current share price by its number of outstanding shares.
Investing in Small Cap vs. Large Cap Companies
I’ve always felt that small-cap companies offer investors more room for growth, generally being earlier in their lifespan than more established ‘blue chip’ stocks, but recognise that they can also bring far greater risk and volatility to my portfolio than large-cap companies (those with a capitalisation of $10 billion or more).
Historically, small-cap stocks have outperformed large-cap stocks in terms of growth. It’s fairly obvious that if you’ve got revenues of £1 million a year, it’s far easier to grow by 20% than if you’ve got revenues of £100 million!
Having said that, the issue of whether small or large companies perform better varies over time based on the broader economic climate. For example, large-cap companies dominated during the tech bubble of the 1990s, as investors gravitated toward large-cap tech stocks such as Microsoft, Cisco and IBM. After the bubble burst in March 2000, small-cap companies became the better performers until 2002, as many of the large-caps that had enjoyed immense success during the 1990s haemorrhaged value in the ensuing crash.
Having skin in the game
Companies run by people with large ownership stakes have extra incentive to see the stock flourish. Some of my best equity performers have had strong management ownership stakes. Smaller businesses tend to have a more significant portion of the company owned by management, simply due to the age of the business and their inability to attract funding from other sources in the early days of operations.
When I take positions in a small cap stock, I buy large amounts because I’ve found that few stocks meet my high standards for quality as investment candidates.
Taking size in any stock is predicated on research. The more I know about the company, the markets they operate in, and their competitive landscape, the more shares I feel comfortable adding to my portfolio.
Conclusion
Although I’m more interested in generating income than growth, I recognise the valuable part that small-cap stocks play as growth opportunities for my portfolio. I always examine sales and revenue figures over the last few years to determine whether they are growing sequentially. I make sure there’s parity between the growth rate of sales and receivables, as the two benchmarks should track each other in terms of percentage growth. If the sales are genuine, I examine margins to ensure current gross margins are stable to rising.
My final piece of research is possibly the most important. Is there any emerging technology coming that could leapfrog the company’s proprietary position in the marketplace? By researching trade and industry journals, and speaking to key players in the industry, I can quickly gain a sense of whether the company is likely to thrive or be leapfrogged during the intended course of my investment.