Small cap companies are an enticing prospect for many investors. They represent companies with a market capitalization of between $300 million and $2 billion. These companies are typically startups or recently out of the startup phase—still small fish in a big pond.
While they’re present in every sector and represent a diverse range of companies, small companies share some unique traits that make them investment targets. For starters, they usually have an appealingly high share price. They’re also frequently overlooked by institutional investors. While this tends to mean low liquidity, it also signals great upside. How long until a small company breaks into the mid cap range and becomes a hedge fund darling? It’s a question worth asking when evaluating a promising small cap stock.
These companies offer a lot of potential upside, but they’re not without risk. Here’s a look at what you need to know about this group of up-and-coming companies.
Small Cap vs. Other Caps
The best way to understand small market capitalization is in the context of the market cap scale. A valuation of between $300 million and $2 billion seems like a lot compared to a micro cap company (less than $300 million). But at the same time, it’s much less than a mega cap company like Apple (Nasdaq: AAPL) or Microsoft (Nasdaq: MSFT)—both worth over $1 trillion. Here’s what the scale looks like and where small caps fall:
- Mega cap: $200 billion to $1 trillion
- Large cap: $10 billion to $200 billion
- Mid cap: $2 billion to $10 billion
- Small cap: $300 million to $2 billion
- Micro cap: $50 million to $300 million
The capitalization range of small caps ($300 million to $2 billion) represents a big stretch of milestones. It takes a lot for a company to become a $500 million company. The stretch to a billion-dollar market capitalization is even more difficult. Doubling it again is nothing short of monumental. This is why so many small companies stay small, and why the difference between small vs. large companies is so significant.
Large cap companies don’t face this struggle. They have the revenue apparatuses in place to maintain and grow, and are well-established in their markets. Think of it like trying to pedal a bicycle. Getting up to speed takes work; maintaining that speed is easier. It’s the same concept of momentum for burgeoning small companies.
What Determines Market Capitalization?
Market cap comes from the value of the company based on its current share price and the total number of shares issued. It’s a relatively simple equation that’s always in flux (due to share price). For example, if XYZ company has 25 million outstanding shares at a price of $39 per share, its market capitalization is $975 million. This puts it firmly in the small market range.
If over the next five years the share price rises to $104, the company’s market cap becomes $2.6 billion. This moves it to mid cap. It can also slide down into micro cap territory if it undergoes hardship and the share price falls.
Examples of Small Cap
It’s difficult to provide common examples of smaller market capitalization companies, for a couple of reasons. First, most ubiquitous brands are popular enough to achieve a valuation that’s well-into the mid cap or large cap range.
The closest real example of a small yet popular brand is Crocs (Nasdaq: CROX), the apparel footwear company. That said, the company recently transitioned out of small cap status into medium cap territory, with a market capitalization of ~$5 billion (as of March 2021). The year before, it was perhaps the best example of a “major” small cap company.
The fact is, most small companies are relatively unknown. They’re still up and coming or have floundered around in this territory for so long that investors have begun passing them over. It’s not often you screen for small caps and a see a name or ticker you’re familiar with. However, you might see a ticker symbol that one day makes headlines as a fast-moving growth stock!
Where to Find Small Companies?
Finding quality companies to invest in can be difficult. Many don’t have the cash to meet NYSE or NASDAQ listing fees. Those that do hardly come up in stock screeners for more established metrics. That said, there are a few places that are home to promising up-and-comers:
- The Russell 2000 Index is a small-cap index that tracks the performance of the smallest cap companies listed on the major exchanges. Alongside the Russell 3000 Index, they’re the most reliable barometers for burgeoning companies.
- Stock screeners are a great way to identify these companies. Make sure the overarching criteria is a market cap below $2 billion, then continue to refine the search to pull up companies with good fundamentals.
- OTC markets are home to lots of micro cap companies, with a few promising small caps sprinkled in. These are often foreign companies or those that can’t (or won’t) pay the listing fee set by major exchanges.
- Small cap ETFs are a gateway to lower-risk investing in these companies. There are growth ETFs, value ETFs and even emerging market ETFs! It’s a smart way to apply your investing style to a small business focus.
Great companies don’t stay small for long! While the range doesn’t change, the companies within it change frequently. It takes quite a bit of due diligence to keep up with them—and even more to pinpoint a diamond in the rough.
Investing in Small Businesses
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Smaller companies are the epitome of risk-reward. They offer an entry point for investors who want to get in at the ground floor of a company that has a good runway for growth. That said, the fundamentals need to justify the investment. Small companies can only grow if they’re backed by good leadership, a competitive advantage, and an addressable market. For these reasons, many small companies languish, instead of flourishing. Still, there’s upside for investors with the tolerance and patience to finance small cap companies.