Small-cap stocks tend to be misunderstood, and as a result, investors often miss out on very lucrative opportunities. Many individuals have amassed large fortunes by investing in these types of stocks. Here are 6 reasons why you should invest in small cap stocks.
1. Higher Potential for Growth
A small-cap stock is a type of stock with a market capitalization between $300 million to $2 billion. Many successful companies were traded as small-cap stocks at one point in time. Consider the astronomical success of Monster Beverage Corporation.
Monster Beverage Corp is the most successful US stock of this century. When Monster’s shares first went public in 2003, they sold for $0.10 per share and the company had a market value of less than $1 million. Today the company is worth around $56 per share with a market value of $29 billion. That’s over a 60,000% increase within the past 2 decades.
As you might imagine, early adopters Monsters Beverage Corp stock would have saw their investments grow exponentially. This is the benefit in investing in micro-cap and small-cap companies. These types of companies offer a chance for investors to get in on the ground floor with younger businesses that may have a higher ceiling of potential.
As a company matures, it becomes increasingly difficult for that company to grow organically. This is because if a company becomes very successful, it will grow to address a large portion of its target audience, which makes further organic growth difficult. As a result, large-cap stocks may take a long time before there is any return or significant growth on investments.
Small-cap companies are usually younger and can grow in ways that are simply impossible for mid-sized or large companies. Companies in their early stages and have the potential to maximize on investments since they can still grow organically. Such equity increases can come in forms such as buyouts, new discoveries or developments and/or strategic acquisitions.
For example, a mining company could be trading at $0.04 per share before entering the exploration stage. However, during the exploration stage, the company finds a gold vein or another valuable source in the mine. This new discovery will propel the value of the stock to rise rapidly, and each share could grow to be worth over $1 almost instantly.
2. Thinly Traded
Small-cap stocks are usually more thinly traded than larger stocks. This means that there is a lower number of buyers and sellers. Although this can be a double-edged sword, careful investors can use this as a tool to increase returns on their investments.
When a company grows, their reported revenues and earnings may grow as well. As the pubic becomes more aware of a company and its future potential, they will seek to invest. However, since there is a low amount of shares available, the prices of each individual share will rise significantly.
3. Financial Institutions Don’t Invest
Financial institutions must comply with strict regulations set by the SEC, which prevents these institutions from heavily investing in small-cap companies. This allows individual investors to purchase shares at a price that is not artificially inflated by financial institutions.
In addition, when these companies reach a level of success where institutions can invest, the institutions will buy a large number of shares and significantly raise prices. These raised prices will greatly benefit pre-existing shareholders.
4. Unknown Values
Small-cap companies have very little analysis coverage compared to their mid-cap and large-cap counterparts. As a result, it is highly possible that the listed value of a small cap company is not reflective of the true value of that company. This inefficiency in the market creates opportunities for individual investors to obtain optimum pricing on shares and receive high returns on those investments.
5. Company Flexibility
Small-cap companies are usually smaller in size and run by a more intimate management staff. As a result, these smaller companies are able to adapt to changing market conditions with quicker haste. This is exactly what happened between Netflix and Blockbuster.
Netflix went public with their stock in 2002, selling at $15 per share with a market value of around $300 million. One of their main competitors, Blockbuster, had a firm hold of the market during this time and, in 2004, was worth around $5 billion. However, Blockbuster was slow to adapt to changing market trends and technologies, such as the popularity of video streaming. This eventually led to the company declaring bankruptcy. On the other hand, the management at Netflix was quick to identify and adapt to market trends, which led to it becoming the iconic company it is today.
6. Diversification
Small-cap stocks have less liquidity than large-cap stocks and, as a result, it may be difficult to buy and sell them at optimal prices. Although it may seem contradictory, this lack of liquidity may actually be beneficial in certain circumstances.
If the market shifts and a large number of investors seek to purchase less-liquid stocks, then the lack of liquidity can be greatly beneficial to pre-existing small-cap stock owners. The increased demand for less-liquid stocks will inflate prices for small-cap stocks more quickly and significantly than the higher liquidity large-cap stocks.
Carefully selecting small-cap stocks and investing in them can add to the overall quality of your portfolio through diversification. Since the liquidity of these large-cap and small-cap stocks respond differently to market influences, the losses of one side might be mitigated by gains on the other.
Small-cap stocks are often misunderstood and suffer many claims that may not necessarily true. There are many reasons to invest in small-cap stocks, and the diligent investor can turn these stocks into very lucrative opportunities.