Small-Cap Stocks

Some of the best investment stories of the past 25 years started with investors who recognized the potential of a small-cap stock. Just think of being an early investor in a company like Amazon (NASDAQ:AMZN), which was a $7 stock in 1998, or Tesla (NASDAQ:TSLA), which had a market cap of just over $1 billion in 2010.

Of course, not every small-cap stock becomes a giant. Investing in the stocks of small companies can be very rewarding, but it comes with risks that investors need to understand. Here’s a closer look at what small-cap stocks are, how to choose the best ones, and how to figure out if they’re right for you.

What are small-cap stocks?

Small-cap stocks are stocks of companies with a small market capitalization (the cap in small-cap). We say that a stock is a small-cap stock when the total value of all of the company’s shares outstanding -- meaning the shares held by all shareholders, including company insiders -- falls roughly between $300 million and $2 billion.

Small-cap companies are often young companies. They tend to have strong growth potentials, but also generally have less stability and market share than larger, more established companies.

Investing in small-cap stocks may be comparatively risky, but the rewards can also be greater. In general terms, the smaller the company, the greater the risk associated with investing in its stock.Micro-cap stocks -- the stocks of companies with market capitalizations under $300 million -- are considered by many as having too much risk.

Since 2000, small-cap stocks have outperformed large-cap stocks by an average of two percent per year. But over shorter periods (three to five years or so), the same is not always true. The prices of small-cap stocks tend to be more volatile than those of larger companies, and the stocks' values fluctuate more dramatically. The longer the evaluation period, the greater likelihood that small-cap stocks outperform the large-caps.

In early 2020, small-cap stocks' performance was trailing behind that of the large-caps; the small-caps proceeded to lose much more of their value during the stock market crash in March. The small-caps also recovered faster, and their values surged after Pfizer (NYSE:PFE) and BioNTech (NASDAQ:BNTX) together announced that they had successfully developed a coronavirus vaccine. The stock of online bank Axos Financial (NYSE:AX), formerly considered a small-cap, gained so much value that it has since graduated to mid-cap territory -- a common occurrence for the small-caps.

As further proof that small-cap stocks are performing well in the recovery, the small-cap-focused Russell 2000 Index (RUSSELLINDICES:^RUT) grew by 18.3% in 2020, while the large-cap-focused S&P 500 (SNPINDEX:^GSPC) gained just 16.3%.

Despite the Russell 2000 Index beating the S&P 500 for 2020, during most of last year large-cap companies outperformed the small-caps. Large companies are more likely to be profitable, have more cash on their balance sheets, and can access external capital more easily. All of these advantages make their stocks less risky investments in a crisis like the COVID-19 pandemic. Many investors seeking to protect their portfolios during the early stages of the crisis likely moved money out of small-cap stocks and into the large-caps. The reason that the Russell 2000 Index ultimately outperformed the S&P 500 for the year is because, with the market recovering, investors are buying small-cap stocks again. This resurgence in the popularity of small-cap stocks is causing them to regain lost value faster than their large-cap counterparts.

Some top-notch small-cap stocks

Many small-cap stocks aren’t household names -- at least not yet. Here are some small caps to consider:

• Carparts.com (NASDAQ:PRTS) is an auto parts company. Formerly known as U.S. Auto Parts, Carparts.com has recently transformed under new management, which is investing in technology and marketing and just opened two new distribution centers. By consolidating its web brands under only the Carparts.com banner, the company has shifted to a singular branding strategy. Sales have surged during the pandemic, which has boosted both e-commerce and auto parts sales. (Cash-strapped consumers are more often choosing to repair existing vehicles rather than buy new ones.) And even after the pandemic, the online retailer's turnaround efforts should continue to drive growth, as the auto parts sector is ripe for disruption.
• ACM Research (NASDAQ:ACMR) is a manufacturer of cleaning equipment for semiconductor wafers, making it a "picks-and-shovels" play in the semiconductor industry. Investing in ACM Research provides exposure to a high-growth industry without having to worry about commodity chip prices declining. Additionally, ACM is an American company but conducts most of its business in China, giving investors a relatively safe way to gain exposure to the Chinese market.
• Yext (NYSE:YEXT) helps to ensure that the information online about companies like restaurants and hotels is current and accurate. Have you ever searched for a restaurant's menu or location only to find that it's outdated? Yext's service has become even more valuable during the pandemic, as many businesses have been temporarily forced to close.

If you don't want to guess at which small-cap stocks are the best for your portfolio, you can instead gain exposure to small-cap companies by investing in a fund that focuses exclusively on small-caps. Here are a couple options:

• iShares Russell 2000 ETF (NYSEMKT:IWM) is anexchange-traded fund that tracks the performance of the Russell 2000 Index, which is considered the leading index of small-cap stocks.
• Fidelity Small Cap Growth Fund (NASDAQMUTFUND:FCPGX) is amutual fund that invests in small-cap stocks that have high growth potential. It's actively managed, meaning that its manager actively monitors and adjusts the fund's holdings in order to beat the Russell 2000's performance. The fund's fees are somewhat higher than those of an index fund, but being actively managed produces (theoretically, at least) superior returns that more than cover those fees.

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How to evaluate a small-cap stock

The Motley Fool’s co-founder, David Gardner, believes that there are six signs of disruptive companies with high growth potential. He calls these kinds of stocks “Rule Breakers.” (For a deeper dive into this concept, check out David Gardner's Rule Breakers podcast.)

Top small-cap companies often exhibit the six characteristics of disruptive businesses that Gardner defines:

• Its leaders are visionaries. Strong leaders envision ways of doing business that are new and different and create opportunities; these leaders can explain their visions in compelling ways.
• The company enjoys a “first-mover” advantage. A company that is first to move into a new market or product category typically benefits from an advantage over its competitors.
• The company's competitive advantages are obvious. These advantages may include network effects (like those enjoyed by Facebook and Uber), high switching costs (which make it difficult for consumers to switch to the company's competitors), or a well-known brand.
• Its branding is strong and loved by customers. A strong brand imparts a sense of meaning for customers; passionate or enthusiastic customers are more likely to exhibit loyalty to the company.
• The company has a track record of rewarding investors. The company's management values its shareholders, which it demonstrates by rewarding them with above-average returns, and perhaps also dividends and share buybacks.
• The company is not without its detractors. A company with high growth potential often receives the critique that its stock price is too high. This is actually a good sign -- if the above characteristics are also present -- because it means that other investors are starting to recognize the company’s potential, not just its performance to date.

Usually the top small-cap stocks also have histories of earnings and revenue growth. Ones that don't deserve closer scrutiny. Below, find details on each of these metrics.

Should you invest in small-cap stocks?

Are you willing to hold an investment for several years? Are you comfortable with stocks in your portfolio experiencing big price swings, both up and down? (Are you sure?)

If yes, then small-cap stocks might have a place in your portfolio. As we've seen, small-cap stocks can boost your portfolio's overall growth rate, as long as you stick with a buy-and-hold strategy. But remember, small companies are more likely to fail than large, established companies, as was recently demonstrated during the coronavirus pandemic. It's important to conduct the necessary research before investing in a small-cap stock.

Of course, you don't personally have to pick individual small-cap stocks to benefit from their presence in your portfolio. Owning a small-cap mutual fund or ETF as part of a diversified portfolio is a viable option for many investors.