Small-Cap Stocks: What They Are & How You Can Earn Profits

Looking for a way to diversify your portfolio? Small-cap stocks might just be the answer.

These stocks hold a lot of potential because of their unmatched growth.  Top investors like Warren Buffett and Peter Lynch got their start by investing in small-cap stocks. Whether you’re an expert investor or novice, small-caps stocks are definitely worth looking into. You might just make more profit than you think.

What Are Small-Caps?

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Small-cap stocks are shares from a small business with a low market capitalization. Typically, these companies have a market cap between $300 million and $2 billion. Small-cap companies are usually in their expansion phase, meaning their GDP grows for two consecutive quarters after a sort of plateau. All big-name companies that we know today, like Walmart and Apple, were once small-cap companies.

Pros and Cons

Small-cap stocks are appealing because they could potentially rake in large returns. On the other hand, they are some of the most volatile investments on the market. A single share can fluctuate 5% or more in a trading day. This lack of stability can be frightening to some. Here are the main pros and cons of small-cap stocks:

Pros

Unmatched Financial Growth. Because they are in the expansion phase, they have the potential to skyrocket. Small-cap companies tend to increase their earnings much faster than large-cap companies due to their smaller operational and financial base. It is much easier for a small-cap company to double in value, for example jumping from $1 billion to $2 billion; the same is not true for large companies.

Less Analyst Attention. Since small-caps are not usually well-known, they garner less attention. This is a good thing because it means that a small-cap stock could be worth more than it seems. Investing in an undervalued stock could be a great way to make big returns.

Perform Well In Early Economy Recovery. In an economic recovery, interest rates are low. This gives small-cap businesses easy access to funds so that they may invest in their growth and continue to push development.

Cons

Not financially stable. Although small-cap stocks could bring in huge returns, the opposite is true. They could also tank and leave you with nothing. This happens because small-cap stocks are vulnerable. Since they don’t have as many financial resources as their larger counterparts, when economic turmoil hits, it can be catastrophic to them. They are high-risk investments since small-companies are in a make-or-break stage.

Takes Time and Dedication to Invest. Less analyst attention is a good thing because it means you could invest in undervalued stocks, but it also carries a downside to it. Because small-caps do not receive many analyst ratings, you will have to research what you wish to invest in. The information to small-caps is not readily available like it would be for Tesla or Apple. You need time and dedication to conduct thorough research to ensure the small-cap you are investing in is worthy of your money.

Poor Performance In a Recession. Small-cap companies have significantly smaller margins and resources, making their performance in a recession or any other economic downturn poor. They do not have any cushion to get them through financial crises, so they are susceptible to bankruptcy and failure.

How To Earn Profits Through Small-Caps

Small-cap stocks could be a lucrative investment if you know which companies to invest in. In order to earn profits through small-cap stocks, you need to do the right kind of research to find out which companies are promising. This means doing the following:

Know The Market You’re In

The first step in finding a small-cap company that you can earn profits from is to know the market you’re in. When it comes to stocks and investing, there are two types of markets: a bear market or a  bull market. A bear market happens when there are prolonged price declines, and a bull market is the opposite, typically characterized by upward-trends.

The best time to buy small-cap stocks is during a young bull market. This could up your chances of making a profit since small-caps tend to outperform in an economy that is growing and strengthening. Do not invest in small-caps during a bear market—you could end up losing money.

Look For Market Shifts

A good way to narrow down the type of small-cap to invest in is to analyze the market for any shifts. Market shifts happen when a new need arises and there are few companies that offer solutions. For example, around the 90s there was a shift from CD to DVD format. Many people were not prepared for this market shift; few companies had the software to facilitate this change.

This meant that the few companies that did have this software were suddenly in great demand because they provided a scarce solution to a niche market. This allowed them to grow and shoot up in value, making stockholders large profits.

This shows that the key to making ample returns is to look for market shifts since they impact the price per stock of small-cap companies. To do this, analyze different types of industries and stay in the know about new developments in these industries. This could give you insight into the next big upcoming trend, helping you decide which company to invest in. Industries that could have significant market shifts are the medical, cannabis, or technology industry.

Analyze The Numbers

Although each step is equally important, looking at the numbers is what will ensure that you are investing in a small-cap with big potential. Looking at the numbers means study any financial information you can get your hands on regarding the small-cap you are considering.

Keep an eye out for past performance and earnings, as these are good indicators of future performance. Also look for revenue growth over 20%, a major characteristic of a promising stock. Do not be alarmed if when researching tour stock you see small profit margins. Because small-cap companies are in their expansion stage, this is typical. Other things to look for are:

  • A lower price-to-earnings ratio
  • A lower price-to-sales ratio
  • Past price appreciation indicating growth
  • A total addressable market that has the potential for the company to grow
  • Optionality that shows this company can address multiple needs and be versatile

Looking for these things might prove difficult because of the scarce attention that small-caps receive, but the information is still out there. Companies usually post all of their metrics and data online or to different platforms. You can find earnings reports, press releases, and more, it will just require elbow grease.

The Bottom Line

Small-cap stocks could be a lucrative addition to your portfolio. As always, do your research and do not invest in anything that you do not feel comfortable with. To help offset any losses, ensure that you have a diversified portfolio. Small-cap stocks are risky, but you might just end up investing in the next big thing.

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Interesting related article: “What is a Portfolio?