While larger stocks might dominate the headlines, especially over the past few years as the Magnificent Seven have blazed a path across markets, small-cap stocks are still a key player in the equity market’s landscape. These stocks’ distinctive positioning allows investors to explore promising investments often overlooked by the mainstream. Don’t be fooled by the ‘small’ in small-cap. Historically, they’ve yielded greater profits than their large-cap counterparts and carry substantial benefits, including the potential for significant returns and broader diversification for a balanced portfolio.
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What are Small-Cap Stocks?
Equities markets consist of publicly traded companies’ stocks. To assess these stocks, investors commonly use a measure known as market capitalization, which is essentially the total dollar value of the company’s outstanding shares. Categorizing companies based on their market capitalization offers insights into their size, value, and potential investment risks, allowing a point of comparison between companies.
Morningstar categorizes small-cap stocks as the bottom 10% of the equity market based on market capitalization. While smaller in aggregate dollar value, this equates to a significant number of the companies that make up the market. For example, the Russell 3000 index (IWV) represents approximately 98% of the investable U.S. equity market. The bottom two-thirds of that index – the Russell 2000 (IWM) – is recognized as a comprehensive representation of the small-cap universe.
For practical purposes, if you use a tool like the Stock Screener, small-caps tend to be defined as having a market cap between $300 million and $2 billion (below that fall micro- and nano-cap stocks, which can often be found among Penny Stocks).
Understanding the Nature of Small-Cap Stocks
Small-cap stocks have traditionally been perceived as more economically sensitive due to their greater focus on domestic markets and dependency on interest rate trends, consumer demand, and commodities pricing.
Access to credit is also crucial. Small-cap companies generally have less access to credit, with about a third financed with floating rates, making them more sensitive to interest rate changes. This prevalent financing structure has presented more challenges for the small-cap space, especially in the past few years, as interest rates have increased.
Historically, the sector composition of small-cap stocks has typically been less exposed to technology and more reliant on slower-growth sectors like consumer cyclicals, financials, real estate, and industrials. However, the wave of innovation powered by artificial intelligence (AI) opens up significant opportunities for smaller firms across various sectors, including new technology start-ups.
Benefits of Investing in Small-Caps
Historically, small-cap stocks have outperformed their large-cap equivalents. This performance is backed by extensive academic research.
In the early 1990s, economists Eugene Fama and Ken French published groundbreaking research that identified specific “risk factors” that helped explain the long-term risk and return performance of assets going back to 1926 (follow-up research has extended that timeframe in many cases).
One factor they identified was the “size effect” – smaller stocks tend to outperform larger stocks over time. There are several working theories for why that is the case:
- They offer compensation for additional risk exposure
- They exploit preferences or beliefs some investors have
The size effect can be seen around the globe and has been particularly strong in international and emerging markets.
These stocks often show lower correlations with larger stocks, providing a unique angle for diversification. Including small-cap stocks in your investment portfolio can contribute to more effective diversification, potentially reducing overall risk exposure.
Further, small caps often aren’t as closely analyzed by Wall Street, which can lead to unexplored investment opportunities. Astute investors who are diligent in their research can uncover emerging companies with the potential for significant growth.
Current Landscape of the Small-Cap Universe
Over the last decade, market dynamics have evolved significantly, with size and scale substantially benefiting larger corporations. Investments in new technologies have upped the competition and disruptions from large-cap companies, making it difficult for smaller firms to keep up. Yet, the playing field is beginning to level out, with technological advancements bringing new opportunities such as cloud computing, AI advancements, and electric vehicle manufacturing, allowing small-cap companies to innovate and compete in new markets and reach new customers.
Changes in macroeconomic factors have also contributed to recent large-cap outperformance, as the past few years have presented challenges for the more interest rate-sensitive small-caps. However, the Federal Reserve’s interest rate cuts and subsequent potential for market growth could be catalysts for rekindling small-cap outperformance.
Finally, the recent relative underperformance of small-cap stocks could be due to a decline in publicly listed U.S. companies thanks to an increase in mergers and acquisitions, especially large tech companies snapping up small start-ups. For instance, since the late 90s, Google (GOOGL), Microsoft (MSFT), Apple (AAPL), Meta (META), Amazon (AMZN), and NVIDIA (NVDA) have acquired over 870 companies. However, the rise in regulatory scrutiny of such practices in the U.S. and Europe could pave the way for increased listings for small caps.
Bottom Line on Investing in Small-Cap Stocks
As you map out your investment strategy, consider adding small-cap stocks to the mix. Whether you decide to gain exposure to the small-cap universe by selecting an ETF or a fund that mirrors an index or prefer to sit in the driver’s seat and choose companies you believe in, small-caps offer opportunities to enhance your portfolio. Though these stocks bear inherent risks such as higher volatility and liquidity challenges, they also promise potential superior long-term returns and diversification benefits.
