Small Cap Stocks

The term "small cap stocks" is often used to refer to common stocks issued by companies that are considered "small" relative to their total market capitalization.  There is a great deal of investor interest in small cap stocks because they offer some noteworthy advantages.

For example, because of their size, a small cap stock can offer investors growth opportunities beyond those of large cap stocks.  In addition, there is market research that indicates the return on investment for small cap stocks may be greater than their larger siblings.

Small Cap Stocks Defined

The total market capitalization of a company is simply defined as the current market price of a stock times the number of shares outstanding.  For example, if Company ABC is selling for $30 per share and there are 30 million shares outstanding, then the market capitalization of Company ABC is $900 million.

If you ask ten different investors, you are probably going to get ten different answers as to the exact definition of a small cap stock.  The consensus seems to be that small cap stocks have a total market capitalization of less than $2 billion.  Even smaller ompanies with market cap below $300 million -  sometimes referred to as mini or micro-cap stocks - are probably too small for this category and best place in the riskier category of Penny Stocks.  So our working definition of small cap is a company with market valuation between $300 million and $2 billion.

Advantages of Small Cap Stocks

There are some real advantages that small cap stocks can offer investors that large companies cannot offer.  Generally, large market capitalization companies - also referred to as blue chip stocks - offer the investor a strong and stable outlook.  They are well-established companies that are cautious in their operational and strategic moves.  These same attributes make it difficult for large companies to grow rapidly.

Small cap companies tend to be much more aggressive than their larger counterparts.  They eagerly seek out new market opportunities and are interested in rapid growth.  This is usually easier for them to accomplish because they may be offering a product or service unlike those existing in the current marketplace.  In return, this allows small cap companies to grow more rapidly than large companies and all the benefits flow to their investors.

Disadvantages of Small Cap Stocks

One of the disadvantages of a small cap stock has to do with dividends.  Investors looking for a steady stream of income from dividend payments may want to look elsewhere.  Many small cap stocks do not offer dividends to investors; instead they use their excess earnings to fuel their rapid growth.

The aggressive growth goals of small cap companies don't always materialize either.  The same market expectations that will drive the price of a small cap's stock upwards, will also drive it right back down.  This makes their stock prices much more volatile relative to larger companies.  If the investor has the risk tolerance for price volatility and the lack of dividends, then they can be often rewarded with higher returns from this class of stock.

Small Cap Stock Theory

Many investors are intrigued with the prospects of higher returns promised by small cap stocks.  And the theories of greater return are not just anecdotal in nature, but backed by studies dating back to 1981.

In his work - The Relationship Between Return and Market Value of Common Stock - Rolf Banz discovered empirical evidence that smaller companies consistently realized overall greater returns for their shareholders than their larger counterparts.  Specifically, Banz found by examining several decades worth of stock information that there was an inverse relationship between the size of the company and the stock's total return to shareholders.

Small Cap Investment Opportunities

Smaller companies are simply more focused on gaining market share then larger companies.  In fact, some large companies have difficulty finding suitable investment opportunities and therefore, return a larger proportion of earnings back to shareholders in the form of stock dividends.  On the other hand, small cap companies will often take all their earnings and reinvest that money right back into the business.

Small companies are often much leaner organizations, being thriftier with the money they have at their disposal.  While many larger companies may be flying their executives around the country in private jets and helicopters, this would be an unusual expense for a small cap company.

Historical Small Cap Stock Returns

To put this small cap theory to test, we've decided to pull some information from Morningstar to compare the three and five year returns on large, medium and small cap stocks.  As of November 2007, here are the total returns for each of these types of mutual funds:

The above table demonstrates that the five year historical returns for small cap stocks are greater than that of large-cap stocks.  In fact, large cap stocks have lower rates of return than those of either mid or small cap stocks in all possible comparisons.   In the shorter-term look (3 Year Return) we do see indications that large cap stock are starting to outpace the growth of small companies.  This fact could be attributed to the recent downturn in the economy which might prompt some investors to switch back to safer investments (larger companies).

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