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.