What is Small Cap Stocks?
Small cap stocks are shares of ownership of small businesses having a market capitalization between $300 million and $2 billion. These stocks have a lower market price and have easier access to funds required for growth. They do reasonably well in an economic recovery but are also the riskiest during an economic downturn.
Small-cap stocks are more likely to fail in a recessionary scenario as they may not have large businesses to survive and are the first to get hit in stress situations. As a result, investors should constantly re-allocate small cap stocks depending on the economic situation prevailing.
Small Cap Stocks List & Examples
Some examples of these small cap stocks list in the US are:
|S. No||Name||Market Cap ($ Million)|
|5||Quintana Energy Services||301.0|
|11||Tsakos Energy Navigation||301.6|
|12||Westport Fuel Systems||301.9|
Why Invest in Small Cap Stocks?
Some of the reasons to invest in small cap stocks are:
#1 – Performance
The small-cap stocks have historically known to outperform the large-cap stocks in the past especially in the US when such stocks gained prominence post the dot-com bubble. Such companies tend to be aggressive players and explore new opportunities for stabilizing their situation.
#2 – Growth Potential
These small cap stocks have a high potential for growth and come up with innovative business strategies. Since many of them are then infancy stages, they do not hesitate in taking risks as growth prospects are measured on the basis of innovation ability.
#3 – Price Advantage
One of the benefits of such investments is that the stocks provide high returns and volatility. This gives the investor the opportunity to extract maximum benefit if potential exists before others can enter. If a particular stock goes skyrocketing, investors have much room for huge returns in the future.
#4 – Lack of Coverage
Small cap stocks do not catch the attention of the analysts in com/parison to the large cap ones. Many of the small cap stocks have high growth potential and could be waiting for the right time to be showcased. This lack of coverage is a tremendous opportunity for investors willing to stay in the long-run.
Small Caps Stocks Impact On Economy
The small caps are critical for the functioning of the economy as well as important options for investors due to the following reasons:
- Small Cap Stocks are generally focussed on domestic business lines and thus are directly related to the performance of the domestic economy
- They spur employment generation in the economy (around 65% of new job growth comes from these firms)
- The Federal Government/ Central Government also offers special loans and grants to these small businesses till a certain turnover
- These companies are well past the initial start-up phase. This will offer comfort to the investors since some base has been formed for the company to survive in the economy. It will also qualify for an IPO (Initial Public Offering).
- The sheer number of small-cap stocks indicates that investors have a large number of options to make their choices from. The internal culture and strategies are where the difference will come down to.
Benefits of New U.S. Corporate Tax Law
- The reduction in the Corporate Tax rate from 35% to 21% is most important for smaller and domestically focused firms. This reform will enable the repatriation of Offshore earnings permitting American businesses to reinvest in U.S. assets. It offers permanent benefits for small firms which have a domestic focus thereby having higher effective tax rates than large companies.
- While the effective tax rates will vary by sector, an average company in the S&P 500 had an effective tax rate of 28% and that of the small cap Stocks focused Russell 2000 Index boasted an effective tax rate of 32%. The overall reduction to 21% shall boost the 2018 earnings for companies in the Russell 2000 Index by 14% compared with 9% for companies in the S&P 500 Index.
- It is unlikely if the small companies will spend the additional cash flows on Capital investments or Acquisitions. They are likely to enhance their value to the large majority of the investors by investing in:
- Leveraged small-cap firms will favour debt reduction as the tax bill restricts a company’s deduction for net interest expense to 30% of EBITDA.
- Despite higher inflation and interest rate offering stability for equities, spurts of improvement in the GDP and rising interest rate cycles have historically proven to be positive for small caps. The magnitude of tax change indicates positive cyclical conditions to continue offering attractive small-cap opportunities. With a possibility of idiosyncratic opportunities, the environment for small caps has become more compelling.
How to Identify Suitable Small Cap Stocks
Though there is no fixed formula for computing small cap stocks certain steps that can be gauged are:
- Search for Paradigm shifts that are opening up new opportunities: One such example was the move from Mainframe computer environment to the Personal computer environment or the move from CD to DVD format.
- Consider investment only when the market opportunity is huge and quantifiable: This will give them an opportunity to establish themselves and take a large market share. Large medical patient populations and new technology users are instances of vast market targets.
- Invest in small cap stocks before the Large Institutions set their Eyes: The strategy here is that subsequent investments by institutions will push up the value of the stock.
- Consider the investment in stocks which offer Value and Growth: The firms may have growth-oriented ideas but its valuation must be reasonable as compared to its peers. From the financial perspective, it should have Balance Sheet with sufficient cash balances and minimum debt obligations. This will offer comfort that companies can survive unforeseen circumstances.
- Avoid Big Losses: Though such small cap stocks tend to be volatile and can face losses, the point is to avoid any repeated or catastrophic losses. The critical component is to determine if the fall is due to fundamentally negative event or trend which undermines the company’s long-term potential or if it is market turbulence. It is here that the fundamental of the firm comes into the picture. If the culture and business model is strong there is a good possibility of attracting lucrative investments.
This has been a guide to what is small-cap stocks? Here we also discuss small cap stocks examples, why invest in such stocks and how to identify such stocks for profitable opportunities. you may also have read through our following articles on corporate finance –
- Introduction to Large Cap Stock
- Stock vs Mutual Funds
- Common Stock vs Preferred Stock
- Restricted Stock Units
- Treasury Stock Method