It’s been said that big things come in small packages, and in investing, few areas embody that idea more than small-cap stocks.
While many of these small but mighty companies might not have the name recognition of say Visa* or Johnson & Johnson, they may possess considerable upside and diversification potential for just about any portfolio. But, like most everything in investing, higher reward often requires taking more risk and volatility, and small caps are no exception.
Understanding what defines a small-cap stock, the associated risks and opportunities, and some ways to invest in this asset class can help investors tap into a potentially attractive source of portfolio returns.
To put it simply, a small-cap stock is a publicly traded company with a relatively small market capitalization. Market capitalization is a common way of measuring a company's total value. It’s calculated by multiplying the stock price by the total number of outstanding shares.
Typically, Wall Street uses the small-cap label for companies with a market capitalization ranging from $250 million to $2 billion.
But this number only tells part of the story. The individual narratives of small-cap stocks are what make them interesting. These companies may be regional businesses looking to expand nationally, biotech firms awaiting a crucial patent, or tech startups attempting to disrupt an established industry. They are agile, hungry, and operating with a massive runway for potential growth.
Sometimes, these are companies that have not yet reached their final form. Other times, these are companies that had found success before backsliding into small-cap territory.
The biggest reason many investors look to small caps is the potential for exponential growth. It’s simple math: doubling a company's revenue from $50 million to $100 million can be much easier than doubling a behemoth's revenue from $100 billion to $200 billion.
When smaller companies succeed, their stock prices can appreciate rapidly. They can also be extremely attractive targets for acquisitions. Large companies often prefer to buy smaller innovators at a premium rather than spending the time and resources to develop competing technology themselves.
The flip side of rapid growth is extreme vulnerability. Small companies typically have less access to capital, fewer product lines, and smaller cash reserves than their large-cap peers.
When economic conditions deteriorate or interest rates rise, smaller companies often feel the squeeze first. A bad quarter can inflict considerable harm on a small company, whereas a massive corporation might barely flinch. This reality leads to higher volatility. The price swings in small caps can be stomach-churning, requiring investors to have both a strong constitution and a long-term perspective.
Yet, for those willing to endure the potential turbulence, research has shown that once macro conditions bottom and the appetite for risk returns, during the last 10 recessions U.S. small caps have historically outperformed U.S. large caps for the 12 months following each such recession.1
When investors want to know how the broader stock market is doing, they often turn to the S&P 500, the traditional benchmark for the overall market. Now, when they want to get a feel for the small-cap market, they may look at the Russell 2000, an index measuring the performance of approximately 2,000 small-cap companies in the United States — and the standard benchmark for this asset class.2
Historically, small-cap stocks have showcased a fascinating performance dynamic. There are long stretches where large-cap stocks dominated the market, leaving smaller companies in the dust. This has been the case of late because of the boom in technology and leading AI companies.
However, history is more than just a few years, and when we extend our window, it’s clear that market leadership tends to rotate.
Following past recessions or periods of significant market downturns, small caps have frequently led the recovery. Because they were more sensitive to the domestic economy, many often bounced back fiercely when economic conditions improved. Some research has shown that over the past 40 years, by following the MSCI Global Small Cap Index investing in certain small caps during recessions could have led to strong investment returns. This historical context reminds us that ignoring small caps entirely can mean missing out on significant market rallies.3
Stock picking in the small-cap segment can be challenging. These companies receive less media coverage and analyst attention, and information is often harder to find. So for most investors, buying a basket of these companies in an exchange-traded fund (ETF) can be a much more efficient approach to gaining exposure.
A small-cap ETF is an investment fund that trades on an exchange and holds a diversified basket of small-cap companies. The idea is that, rather than trying to pick a single company that will outperform, a small-cap ETF lets you invest in the broader asset class.
And what you get from a small-cap ETF will look a lot like what you get from any other ETF: diversification, convenience, transparency, and simplicity.
Now, not all small-cap ETFs are created equal. Many traditional small-cap ETFs track indexes like the Russell 2000, but they come in a variety of flavors—including funds focused on growth, value, or specific sectors.
While passive ETFs track an index like the Russell 2000, active management can be particularly beneficial in the small-cap space.
Passive index funds are forced to buy every company in the index, regardless of quality, track record, or any other bellwether of success. In the small-cap universe, that might mean you’re buying a significant number of companies that may be unprofitable, heavily indebted, or poorly managed.
An actively managed small-cap ETF factors in more experience and more analysis to identify the companies with solid balance sheets, competitive advantages, or capable leadership. Basically, tenured portfolio managers are doing everything they can to avoid an investment landscape littered with landmines.
At Motley Fool Asset Management, we’ve been long-time believers in using ETFs for both active and passive strategies. Learn how we approach small-cap ETFs here.