Small-cap stocks: Risks, rewards, and strategies

Small-cap stocks appeal to investors for their potential for compelling growth as their smaller size allows for faster growth rates compared to established larger-cap firms. As always, this potential comes with heightened risks. This article will unpack the characteristics of small-cap stocks, the representative index, Russell 2000, and an investment strategy for such stocks. 

What are small-cap stocks? 

The definition of a small-cap stock in the US is one with a market capitalisation of between US$300 million and US$2 billion. However, classifications by market cap are approximations, vary from one market to another, and may change over time. 

Example: Russell 2000 Index

In the market, the Russell 2000 Index is the widely known US small-cap index that tracks the performance of the 2,000 smallest US companies based on their market cap. As of 31 October 2024, the average value for a company on the Russell 2000 was US$3.5 billion, while the median market cap was US$962 million, according to the index provider. 

The index’s largest constituent, Ftai Aviation, a company that maintains commercial jet engines, is valued at  US$16.24 billion. For comparison, the largest company on planet Earth, Apple Inc. is now valued at US$3.67 trillion, with the newest investor darling chipmaker Nvidia trailing closely with US$3.65 trillion as of 6 December. 

What's small-cap premia?

Smaller-cap stocks have historically been associated with higher long-term returns compared to their larger-cap counterparts. This phenomenon is known as small-cap premia. 

This small-cap premia concept arises from the notion that smaller companies face greater risks and inefficiencies, making them more susceptible to failure. Consequently, investors expect a higher return on investment to compensate for these risks. 

However, this small-cap premium appears to have diminished significantly over the past decade, as large-cap stocks have outperformed small-cap stocks by substantial margins.

The market seems to be at a critical inflection point, with some predicting a resurgence in small-cap stocks. This optimism is fueled by expectations that the Federal Reserve will continue to cut interest rates, creating a more favourable environment for growth. Additionally, small-cap stocks are currently trading at discounted valuations compared to their large-cap counterparts, making them an attractive option for investors seeking potential upside.

Small cap stocks and their characteristics  

1. Higher risk/reward potential

Small-cap companies often possess considerable potential for growth. Their smaller size allows for faster growth rates compared to established large-cap firms, making them particularly attractive to investors seeking substantial returns. This is as small-caps are at the leading edge of innovation.

This growth potential comes with heightened risks; the likelihood of failure can be significant. Economic downturns or market fluctuations can result in sharp price swings, posing challenges for investors who prioritise stability.

Historically, small-cap stocks have outperformed large-cap stocks over the long term. Small caps in the US, as represented by the Russell 2000 Index, have outperformed the S&P 500 Index since 1998. The latter tracks the 500 leading US publicly traded companies.

Small-caps typically have a larger debt burden with a larger proportion of their debt in floating-rate debt, thereby they are more exposed to higher interest rates. The backdrop of the Fed lowering interest rates could benefit from improving borrowing conditions, increasing investor risk appetite, and offering the potential for outperformance.

2. Market inefficiency

Small-cap stocks are less covered by stock analysts and institutional investors, which can lead to mispricing. The average number of analysts covering small-cap stocks is significantly less than in large caps. A sizable percentage of small-cap stocks that have no analyst coverage. 

Due to minimal coverage, active management is required to identify high-quality small-cap stocks. Small-cap companies with strong balance sheets, high return on equity and competitive advantages that are durable and growing. An index fund may not be able to make the distinction between the quality of the company, thus active management is critical. 

3. Less liquidity 

Most small-cap stocks tend to have lower trading volumes, due to their smaller size. Low trading volumes can lead to wider bid-ask spreads and difficulties exiting positions. 

Other issues like crowded trades can exacerbate liquidity challenges and result in higher share price volatility. 

For example, by moving from the Russell 2000 Index to the Russell 2500 Index, the market cap and liquidity doubled with only the addition of 500 names.

Fitting small-caps into a broader portfolio

Especially after the past decade of strong mega-cap performance, investors’ equity portfolios could be fairly invested in large-cap stocks. 

Quality small- and mid-cap stocks should offer not only the prospect for long-term growth, but also the potential portfolio diversification benefits from investing across the market-cap spectrum.

Current valuations for these firms, coupled with an environment of improving earnings-per-share growth could lead to a wider range of these companies delivering competitive returns. 

Investors looking to participate in the growth of small-caps can check out the carefully curated selection of small and mid-cap equity funds available on the Endowus Fund Smart platform.

<divider><divider>

Risk Warnings

Investment involves risk. Past performance is not an indicator nor a guarantee of future performance or returns. Projected performance or returns is not guaranteed to materialise. The value of investments and the income from them can go down as well as up, and you may not get the full amount you invested. 

Rates of exchange may cause the value of investments to go up or down. Individual stock performance does not represent the return of a fund.

General risk warnings relating to collective investment schemes 

Before making an investment decision, you are reminded to refer to the relevant prospectus/ offering document for specific risk considerations and related fees and charges.

Funds are not a bank deposit and not capital guaranteed, and is subject to investment risks, including the possible loss of the principal amount invested.  

Some of the funds also involve derivatives. Do not invest in them unless you fully understand and are willing to assume the risks associated with them.

Opinions

Any forward-looking statements, prediction, projection or forecast on the economy, stock market, bond market or economic trends of the markets contained in this material are subject to market influences and contingent upon matters outside the control of Endowus HK Limited (“Endowus”) and therefore may not be realised in the future. Further, any opinion or estimate is made on a general basis and subject to change without notice. In presenting the information above, none of Endowus HK Limited, its affiliates, directors, employees, representatives or agents have given any consideration to, nor have made any investigation of the objective, financial situation or particular need of any user, reader, any specific person or group of persons. Therefore, no representation is made as to the completeness and adequacy of the information to make an informed decision. You should carefully consider whether any investment views and products/ services are appropriate in view of your investment experience, objectives, financial resources and relevant circumstances. You may also wish to seek financial advice through a financial advisor or the Endowus platform and independent legal, accounting, regulatory or tax advice, as appropriate.

No invitation or solicitation

Nothing contained [in this article] should be construed as a solicitation, an offer to buy or sale, or recommendation, to acquire or dispose of any security, commodity, investment or to engage in any other transaction in any jurisdiction in which such solicitation, offer to buy or sale would be unlawful under the securities laws in such jurisdiction. No information included [on this website/ in this article] is to be construed as investment advice or as a recommendation or a representation about the suitability or appropriateness of any advisory product or service; or an offer to buy or sell, or the solicitation of an offer to buy or sell, any security, financial product, or instrument; or to participate in any particular trading strategy. Investors should seek independent financial and tax advice before making any investment decision.

Product Risk Rating: Please note that any product risk rating (the “PRR”) provided by us is an internal rating assigned based on our product risk assessment model, and is for your reference only. The PRR is subject to change from time to time. The PRR does not take into account your individual circumstances, objectives or needs and should not be regarded as advice or recommendation to purchase, hold or sell any fund or make any other investment decisions. Accordingly, you should not solely rely on the PRR in making your investment decision in the relevant Fund.

Complex Products

Some of the funds contained in this article are complex products and investors should exercise caution when investing in these products. Though these products have been authorised by the SFC, authorization does not imply official recommendation. SFC authorization is not a recommendation or endorsement of a product nor does it guarantee the commercial merits of a product or its performance.

This advertisement has not been reviewed by the Securities and Futures Commission or any regulatory authority in Hong Kong.