Strictly defined, small cap stocks are companies with a low market capitalization (or the value of all their outstanding shares). Where the line is drawn between small cap stocks, mid-caps and large caps can vary depending on whom you ask, but small caps generally sport market caps of about $250 million to $2 billion.
You might consider stocks below $250 million as “micro-caps.” If you want to go even smaller, there is the “nano-cap” category, which refers to stocks with market caps of $50 million or less.
The advantage of investing in the best small cap stocks is the prospect of higher returns: according to a study by Ibbotson & Associates, small cap value stocks (or small cap stocks that also boast bargain price-to-earnings or price-to-book ratios, for example), posted a compound annual return of 14.1% between 1927 and 2010, ahead of both large cap value stocks, with 11.1%, and large cap growth, at 8.8%.
To put that in dollars and cents, $1 invested in small cap value stocks in 1927 would be worth $49,822 today, versus $5,605 for large cap value stocks.
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The downsides of small cap investing aren’t hard to guess. For one, these stocks are typically more volatile than their larger cousins. Small caps can also fall faster than large caps in a declining market. Another thing to keep in mind: dividends are rare in the small cap universe, as companies prefer to plow their profits back into the business in order to drive their growth.
A Roadmap to Picking the Best Small Cap Stocks
Jim Fink, Investing Daily’s chief investment strategist for the Options for Income, Personal Finance and Roadrunner Stocks advisories, is our resident expert on small cap investing.
Fink uses a number of criteria to pick the best small cap stocks for Roadrunner Stocks, which focuses on investing in smaller firms. Here’s a brief look at five things he likes to see before he adds a small cap stock to his shortlist:
- Impressive management: “The greatest idea or breakthrough product means nothing unless you’ve got smart, dedicated people running the show—preferably the founder,” says Fink. “I’ve made more money investing in firms with sharp managers and so-so products than in companies with great products and mediocre management. And the smaller the company, the better the management has to be.”
- A unique product or service: Fink likes to focus on small companies with something exceptional to offer. Uniqueness gives these firms a strong competitive advantage, because consumers can’t get what they sell anywhere else. In the absence of competition, a company has almost unlimited pricing power.
- Low price-to-earnings ratios—ideally lower than the company’s growth rate, according to Fink. As a target range, he’s especially fond of “shoe-size” P/Es in the 9 to 11 range.
- High and rising operating margins: Unlike earnings, operating margins can’t be manipulated, says Fink. That’s why he considers them a strong measure of a company’s true profitability.
- High insider ownership: “I want management to be partners with us on a stock,” Fink says. “It’s a key Buffett rule: owner-operators want the stock to go up as much as you do.”