An intro to investing in small-cap stocksAn intro to investing in small-cap stocks

First—what’s a small cap?

A small-cap stock (‘stock’ meaning ‘investment’) is a listed company with a small market capitalisation. If you add up all the shares in a small-cap company, its valuation would be between several hundred million and $3 billion AUD. There are also micro-cap stocks which are companies with a market capitalisation of less than several hundred million AUD. 

Small-cap companies are often in the early stages of growth and can be found across all types of industries. 

Advantages of investing in small-cap stocks

Like with all investments, there are risks and potential rewards to weigh up when looking at small-cap shares. Here are some of the main reasons why investors might be drawn to small company investments: 

Growth potential 

In theory, companies with a small capitalisation may have more potential to grow than their larger counterparts (such as blue chip companies), and investors may generally buy into them in the hopes that their investment exponentially increases in value. For example, investing in a small tech company that may develop a breakthrough product.

Portfolio diversification 

Since small-cap companies face different risks and opportunities than larger companies and other investment types, investing in them may help to diversify an investor’s portfolio. 

Some investors use a core and satellite approach when investing in small-cap stocks. Meaning, the bulk of their portfolio might be made up of stable, passive investments (like an exchange-traded fund (ETF) that tracks an index), while only a small portion might be allocated to actively selected investments (including small-cap stocks) that may have a chance of achieving greater returns.   

Access to innovation

Some small-cap companies are at the forefront of innovation by developing new technologies, products, and services that could disrupt existing markets. The thought of investing in the industry leaders of tomorrow can be a big drawcard for some investors.  

Low barrier to entry 

Since small-cap stocks often have a relatively low share price, they can be more accessible for investors to buy. However, with most modern investing platforms—like Sharesies—offering fractionalised investing (enabling you to buy part of a share) this may be less of a drawcard than it has been in the past. 

Risks associated with investing in small-cap stocks

Investing in a small-cap stock is considered a high-risk investment and may not be suitable for some types of investors. Here are some specific risks to be aware of:  

Higher volatility

Volatility refers to how often an investment's share price goes up and down. Small-cap stocks are known for experiencing large, frequent fluctuations in price. This is due to things like economic events (like if interest rates went up and the company couldn’t afford to absorb the cost), less company information being available (analysts are more likely to cover larger companies), or company-specific news (such as a product development attracting many new investors).

Limited resources

Small-cap companies often have limited financial and operational resources. They may struggle to access capital (money), scale their operations, or compete with larger, more established companies. These limitations can impact their growth prospects and increase the risk of business failure.

Lower liquidity

Liquidity refers to how easy it is to buy and sell an investment. Since there are generally less investors trading small-cap stocks (leading to lower liquidity), orders can take longer to fill and it’s harder to know exactly what price you’ll buy or sell shares for. 

Vulnerable to economic downturns

Small-cap companies are often more vulnerable to economic downturns because they may lack the financial stability and resilience of larger companies to weather adverse economic conditions. During recessions or periods of economic uncertainty, small-cap stocks can experience more significant declines in value.

Steps to take before you invest in a small-cap stock

Here are some things you can do to help work out if investing in small-cap stocks makes sense for you and your portfolio:

Do your research

It’s worth doing thorough due diligence before you invest in a small-cap company (or any company for that matter!). Investigate the company's financial statements, management team, competitive landscape, growth prospects, and industry trends to get a better idea of the company's fundamentals and potential risks.

Make sure you’re diversified 

We know that being diversified can help mitigate the impact of one investment performing poorly on your overall portfolio. That’s why it’s important to review your portfolio and think about how adding a small-cap stock into the mix would change things. 

Think about the long term

Since small-cap stocks are known for frequent share price fluctuations, you may not have as much certainty that you’ll get your money back if you intend to hold your investment for the short term. Investing with a long-term view means that the company has more time to grow and potentially increase in value. 

Consider small-cap themed funds

An alternative way to invest in small-cap stocks is through a small-cap themed ETF. These ETFs pool investors' money to invest in a range of small-cap stocks, giving you exposure to the investment type while mitigating some of the risks associated with picking individual investments. To find ETFs like this on Sharesies, search small cap and filter by ETFs. 

Wrapping up

Investing in small-cap stocks presents both opportunities and risks. This type of investment may offer growth potential, portfolio diversification, and access to innovation, but comes with higher volatility, limited resources, and lower liquidity. To help you decide if investing in small-cap stocks makes sense for you, do your research, diversify your portfolio, and think long term.