Small-cap stocks refer to stocks that have a small market capitalization and generally hover between US$300 million and US$2 billion. While investors gravitate towards blue-chip or large-capitalization stocks as they're less risky, small-cap stocks sometimes outperform.
Even in these unprecedented times with the recent pandemic plunging most of the economy into a recession, small-cap stocks have historically emerged more robust than ever. It's also a great time to buy these stocks as they're currently beaten down and inexpensive. Amongst them could also be some of tomorrow’s most successful companies, so purchase the right one and your stocks could skyrocket in value.
Recent reports have indicated that buyers are turning their attention towards smaller, cyclical companies. Why? Well, according to previous market recoveries since 1926, smaller-cap equities were able to outperform in the next 12 months by an average of 10.5%.
Furthermore, a report by Equity-Market Outlook indicated that while both small-cap and large-cap stocks have minute differences in performance during the first few months of a market recovery, small-cap stocks end up outperforming large-cap stocks for the remaining six months. This shift in sentiment builds a compelling case for considering a tactical allocation to small-cap stocks.
While the optimal time frame is a huge bonus, small-cap stocks also come with significant benefits that make them a worthy investment.
Even though small-cap stocks are made up of younger firms, they can be strong investments in the long run for CAGR as they're creating new products and services or shaking up the landscape by building new markets. Remember that companies like Microsoft and Amazon were once small caps, so there's no better way to get your foot in the door – especially if you're new to investing.
As smaller caps, these companies also start out with lower total values with massive growth potential. PolyNovo (PVN), for example, is one such company that has a market capitalization that's 20 times higher than five years ago. That's unlikely to happen to a larger company that may have already maximized its growth potential.
It's not uncommon for big mutual funds to invest massive amounts of money in one company. By purchasing large quantities of stock, these institutional investors end up significantly driving up the price.
With small caps, however, they don't have the market cap to support these large investments. Hence, individual investors who have spotted promising small-cap companies can buy their stocks and get in before institutional investors do.
Small-cap value index fundsSince small-cap stocks have minimal analyst coverage and aren't given much attention from stock exchanges such as Wall Street, they're usually undervalued with high returns. While there is a risk of individual small undervalued companies being more likely to fail than large caps, they're still a safer option than buying a single large-cap stock. Some of the best small-cap value index funds that you can look at include the Fidelity Small Cap Index (FSSNX) and Praxis Small Cap Index (MMSIX).
While small-cap stocks are considered to be more aggressive investments than large-cap stocks and do come with their risks, they're a good stock to look at during market corrections and if you're a new investor. As small companies are more affected by changes within the economic environment, small-cap stocks have seen larger declines in price during the current recession.
Investors that are looking to take advantage of price fluctuations should look to purchase small-cap stocks during this season. Not only is there more growth potential than large caps, in the long run, but you'll also be adding diversification to your portfolio. Since there's less focus from investors, it'll also be easier to find undervalued shares.