Investing in the stock market can be rewarding yet absolutely terrifying. If you’re a budding investor just getting started, you might have questions about which stocks are worth considering. Such questions can even overwhelm a seasoned investor. The stock market offers a myriad of investment options for investors. Among these options are small-cap stocks.
Small-caps are companies that often fly under the radar but can offer substantial growth. Examples of well-known companies that started as small-cap include Monster Beverage Corporation, which is now a leader in the beverage industry, and Under Armour, which began as a small-cap company and has grown into a major player in sports apparel.
New investors often shy away from small-cap companies, but they do offer promising investment growth. In this article, we’ll breakdown everything you need to know about small-cap stocks and share strategies on how you can invest in these hidden gems.
How is a stock classified by market cap?
Market capitalisation (or market cap) is the total value of a company’s outstanding shares of stock. Stocks in the stock market are classified based on their market capitalisation, or market cap, as large-cap, mid-cap and small-cap. Understanding the differences between them will help you make better informed investment decisions. Today, we’ll focus on understanding what small caps are all about.
What are Small-Caps?
Small-caps are publicly traded companies with a market capitalization between RM300 million and RM2 billion. These companies are typically in the early stages of growth, making them exciting opportunities for investors. Examples of Malaysian small caps include PADINI, AEON, and ASTRO.
Characteristics of Small caps
Growth Potential
Small-cap companies often have significant growth potential. They are typically younger companies or companies serving niche markets.
Volatility
These stocks tend to be more volatile than large cap and mid-cap stocks. Their prices can fluctuate widely due to lower trading volumes and higher sensitivity to market conditions.
Risk and Reward
Investing in small cap stocks may seem riskier, but the potential for high returns is also greater. These companies might struggle with limited resources and may be more vulnerable to economic downturns.
How to Spot a Small Cap
Step 1: Identify a small cap
Start scanning for small companies. Get on a stock screener and spot any company with a market cap valued between RM300 million and RM2 billion.
Step 2: Identify a strong business
Next, identify a strong business. Focus your search efforts on finding companies with the potential to deliver explosive growth. That means looking for companies that could be the next Apple or Netflix.
Here’s what to look out for when looking for small caps:
1. Explosive Growth Potential
Focus on companies with consistently increasing revenue. This indicates strong sales and potentially innovative products or services in high demand. Aim for at least 20% annual revenue growth, but be cautious if growth slows, as it could signal a maturing market or fading trend. A classic example of a once-small-cap company is NVIDIA, a leader in graphics processing units. They began their journey as a small-cap company, trading at a mere 35 cents per share in 1999. Fast forward to today, and their share price has skyrocketed by an incredible 229,000%. This phenomenal growth trajectory exemplifies the explosive potential that small-cap companies can offer!
2. Stock Price Appreciation
Evaluate the historical stock price. A steady upward trend suggests investor confidence in the company's future. Conversely, stagnant or declining prices might indicate challenges. Remember, past performance isn't a guarantee, but it offers valuable insights.
3. Total Addressable Market (TAM)
TAM refers to the annual expected sales within an observed market. Imagine the TAM as the size of the problem a company's product or service solves. A larger TAM signifies a broader customer base and more room for growth. For example, an AI company tackling a massive industry like healthcare has a much bigger TAM than one focused on a niche market.
4. Future Profitability
While some small caps may not be profitable yet, they should demonstrate a clear path towards future profitability. Analyse the company's business model, its competitive edge (what makes them unique), and any valuable assets they possess. Look for improving profit margins, even if they haven't reached profitability yet. These signs suggest the company is on the right track.
Small Cap Myths Debunked
Myth | Reality |
Small caps are too RISKY! | While small-cap stocks can be more volatile, this doesn’t necessarily translate to higher risk. The level of risk varies depending on the company’s industry, management, and financial health. Some small-caps are stable and have strong growth potential. For instance, over the past 10 years (as of June 2024), the Russell 2000 has delivered an average annual return of 12.5%, compared to the S&P 500's 10.2%. |
Small-cap companies are generally not profitable. | Some small-cap companies offer attractive dividends due to their historical nature and the desire for yield from families and shareholders. According to Robert Beauregard, these stocks offer a higher dividend yield (2.51%) compared to established indexes like the S&P 500 (1.83%) or the large-cap world index (2.34%). This means you could potentially earn more income from your investments while still enjoying the growth potential of smaller companies. |
Small caps are poorly managed. | Many small-cap companies are led by skilled and experienced management teams who are deeply involved in the company's growth and success. |
Small caps are only suitable for speculative investors. | While small-caps can be more volatile, they are also suitable for long-term investors willing to research and have a higher risk tolerance. |
Should I include Small Caps in My Portfolio?
As an investor, it’s crucial to understand the risks involved when investing in individual stocks. Your investment is directly tied to the performance of the specific company you choose. If you invest in a small-cap company with strong fundamentals and a healthy outlook, the stock is likely to grow over the long term. However, if the company underperforms, your investment could lose value. As mentioned before, small-cap stocks tend to be more volatile, meaning their prices fluctuate more than those of larger companies.
For instance, in 2023, over half of US small-cap stocks lost 10% or more, despite the overall market gaining about 26% for the year.
Thorough research and risk management will be required when considering small-cap investments. If you don't have the time or expertise to make your own trading decisions, consider working with a financial advisor.
There are two ways to invest in small caps:
Buying Individual Stocks: This means you directly purchase shares of specific small companies you believe will show potential growth.
Buying a Fund: This involves investing in a mutual fund or exchange-traded fund (ETF) that focuses on small-cap stocks. These funds hold shares of many different small companies, offering diversification, and are managed by professional fund managers who make investment decisions.
For most investors, a broadly diversified mutual fund or exchange-traded fund (ETF) is a better option than picking individual small-cap stocks. This is because these diversified funds spread your investment across many companies, reducing the risk of losing everything if one company performs poorly.
If you do decide that investing in small-cap stocks is right for you, you can buy and sell shares of individual companies directly through online trading platforms. But, if you find buying individual stocks seems too risky or time-consuming, you can opt to invest in small-cap focused ETFs and mutual funds.
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Tips for Investing in Small-Cap Companies
1. Do Your Research
It’s important for you to do your homework before you start investing in any company. Look at the company’s business model, competitive position, management team, and growth prospects. Financial statements, earnings reports, and market trends are good places to start.
2. Diversify Your Portfolio
Never put all your eggs in one basket. Diversify your investments to manage risk effectively. By spreading your investments across various small-caps and other asset classes, you can balance potential risks and rewards.
3. Consider Small-Cap ETFs or Mutual Funds
If researching individual stocks feels too overwhelming, consider investing in small-cap exchange-traded funds (ETFs) or mutual funds. These funds provide exposure to a basket of small-cap stocks, offering diversification and professional management.
4. Start Small
As a new investor, start with a small investment in small-cap stocks. This allows you to get comfortable with market dynamics without risking too much of your capital.
5. Be Patient
Investing in small-cap companies often requires patience. These companies may take time to grow and deliver returns. Keep a long-term perspective and avoid making impulsive decisions based on short-term market fluctuations.
Conclusion
In conclusion, with adequate research, investing in small caps could be a valuable addition to your portfolio. Small caps may offer you the chance to be at the forefront of innovation and, in some cases, potentially enjoy attractive dividends. Remember that every investment carries risk, so it’s essential to do your homework and consider your risk tolerance before diving in. Diversification is key; consider incorporating small caps alongside large-cap holdings to balance stability with growth potential. Happy investing!
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