When most investors begin their hunt for a new stock, it starts and ends with a large-cap name valued at over $10 billion. They're often the best-known companies in the market and simply easier to find. Think widely recognized companies like Apple, Facebook, Berkshire Hathaway, and ExxonMobil.
While there are many good reasons to own large-cap stocks, it also behooves investors to seek out small-cap stocks -- those with $300 million to $2 billion in market cap. As a group, these companies are much smaller than their larger-cap counterparts and therefore have greater growth potential. Under the right circumstances, small caps are a good bet to outperform their larger peers.
Potential to maximize returns
The best reason to invest in small-cap stocks is their greater potential to deliver outsize returns than larger companies. For instance, it's considerably easier for a $1 billion company to become a $10 billion one than it is for a $100 billion company to grow to $1 trillion. In fact, some of the biggest companies in the world once traded in the small-cap range, like Amazon and Netflix. If you had bought and held these stocks when they were small, you would have seen your initial investment appreciate more than 100 times.
Small-cap stocks tend to have higher growth rates. Again, it's easier for a smaller company to double its revenue, whereas mature companies tend to see slowing revenue growth. However, small caps are also more likely to be unprofitable. This makes them more volatile than large caps, as they are more vulnerable to recessions, market crashes, and other shocks. For example, during the 2020 crash, when the coronavirus pandemic hit the U.S., small-cap stocks fell further than their large-cap peers.
Additionally, small-cap stocks are followed by fewer investors and Wall Street analysts, so they often have bigger swings on news like earnings reports.
When small-cap stocks can outperform large-cap stocks
Due to their higher volatility, small-cap stocks tend to outperform during young bull markets, when stocks are quickly moving higher. For example, since the Russell 2000, which tracks the performance of small-cap stocks, bottomed out on March 18, 2020, it's outperformed the much larger S&P 500 by a significant margin, as the chart below shows.
It's worth noting that the Russell 2000 still trails the S&P 500 on a year-to-date basis for 2020, as the index fell 43% compared to a sell-off of just 35% in the S&P 500. Clearly, small-cap volatility swings both ways.
Similarly, in the heady days of the bull market following the financial crisis, the Russell 2000 also outperformed the S&P 500 by a wide margin. The chart below shows the first year of that bull market.
In fact, the Russell 2000 would go on to outperform the S&P 500 for most of the decade that followed the financial crisis. Smaller companies also benefit from such accommodative monetary policies as low interest rates, which make it easier for them to borrow to expand or keep their businesses afloat during tough times. Similarly, fiscal stimuli are also beneficial for small-cap stocks, as these companies are generally more sensitive to consumer spending and market sentiment. On average, small-caps have an advantage when the U.S. economy is in recovery mode. When the economy is rebounding, unemployment rates are quickly going down, and businesses are seeing strong earnings growth -- this is a great time to invest in small-cap stocks.
Of course, small-cap stocks don't always outperform. Just as these stocks have more upside potential, there's also substantial downside risk, as they're less likely to be profitable and can more easily be pushed into bankruptcy. That makes small-cap stocks riskier than so-called blue chips. But with greater risk comes greater potential for reward.
There are no absolute rules in investing. While small caps historically outperform large-cap stocks, that doesn't necessarily mean your portfolio should consist only of small companies. As always, a healthy balance of different types of stocks is the key. You can also look to index funds and mutual funds to make diversification easier. It's also important to focus on quality rather than just market cap -- it's much better to own a high-quality large-cap stock than a low-quality small-cap one.
Still, scaling up your exposure to small-cap stocks as a group is one tried-and-true way to increase your returns. If you can buy some of the top small-cap stocks early in a bull market, you're likely to outperform the market over the coming years and into the long term.