Small Cap

What Is Small Cap?

The term small-cap describes companies with a relatively small market capitalization. A company's market capitalization is the market value of its outstanding shares. The definition for small-cap varies, but generally means a company with $300 million to $2 billion in market capitalization.

Understanding Small Cap

The "cap" in small-cap refers to capitalization. The term in its entirety, though, is market capitalization. This is the market's estimate of the total dollar value of a company's outstanding shares. To calculate a company's market capitalization, multiply its current share price by the number of outstanding shares (or the number of shares the company has issued to the market).

Keep in mind, however, that classifications such as large-cap or small-cap are approximations that change over time. Furthermore, the definition of small-cap stocks vs. large-cap stocks can vary among brokers.

One misconception people have about small caps is that they are startup companies or are just brand new entities that are breaking out. But this can't be further from the truth. Many small-cap companies are just like their larger counterparts in that they are well-established, have strong track records, and have great financials. And because they are smaller, small-cap share prices have a greater chance of growth. This means they have much more potential for investors to earn money faster.

Investing in Small-Cap vs. Large-Cap Companies

As a general rule, small-cap companies offer investors more room for growth but also confer greater risk and volatility than large-cap companies. A large-cap offering has a market capitalization of $10 billion or higher. With large-cap companies, such as General Electric (GE) and Boeing (BA), the most aggressive growth tends to be in the rear-view mirror. As a result, such companies offer investors stability more than big returns that crush the market.

Historically, small-cap stocks have outperformed large-cap stocks. Having said that, whether smaller or larger companies perform better varies over time based on the broader economic climate.

For example, large-cap companies dominated during the tech bubble of the 1990s, as investors gravitated toward large-cap tech stocks such as Microsoft (MSFT), Cisco (CSCO), and AOL Time Warner. After the bubble burst in March 2000, small-cap companies became the better performers, as many of the large caps that had enjoyed immense success during the 1990s hemorrhaged value amid the crash.

One advantage of investing in small-cap stocks is the opportunity to beat institutional investors. Many mutual funds have internal rules that restrict them from buying small-cap companies. In addition, the Investment Company Act of 1940 prohibits mutual funds from owning more than 10% of a company's voting stock. This makes it difficult for mutual funds to build a meaningful position in small-cap stocks.

A stock smaller than a small-cap is known as a micro-cap, a publicly traded company in the United States that has a market capitalization between approximately $50 million and $300 million.

Small-Cap vs. Midcap

Investors who want the best of both worlds might consider midcap companies, which have market capitalizations between $2 billion and $10 billion. Historically, these companies have offered more stability than small-cap companies yet confer more growth potential than large-cap companies.

However, for self-directed investors, spending the time to sift through small caps to find that diamond in the rough can prove to be time well spent. Even in our data-rich world, great small-cap investments fly under investor radar because of thin analyst coverage. With scant coverage, important company news, developments, and innovations can go unnoticed. By contrast, news coming out of the large tech companies tends to garner a lot of coverage.

Small-Cap Stocks and the Russell 2000

The Russell 2000 is a small-cap stock market index composed of the 2000 smallest companies in the Russell 3000. The index is frequently used as a benchmark for measuring the performance of small-cap mutual funds. The S&P and Dow Jones indices focus on large-cap stocks, thus investors hoping to track small-cap stocks' performance should keep their eyes glued to the Russell 2000 or the S&P600 — a similar small-cap index.