As a result, small-cap stocks carry more risk than investing in large- or mid-cap companies, but the rewards can be great for a well-constructed portfolio.
In this article, you’ll learn what separates large-, mid- and small-cap stocks, how to invest in small cap stocks and which criteria to use to find the market’s tiny but mighty companies.
Small-Cap Stocks Defined
What is a small cap stock? What is small cap, exactly? Companies are divided via sector and industry throughout the market, but also by company size and scope. Think of the biggest and most well-known stocks like Amazon, Microsoft and Google — these are large-cap stocks because their market capitalization (the value of all outstanding shares combined) is among the highest of all companies in the world.
Small-cap stocks “live” at the other end of the spectrum. By most definitions, a small-cap stock has a total market capitalization of $2 billion or less. Mid-cap stocks are usually valued between $2 billion and $10 billion. Anything over $10 billion is considered a large-cap stock. Measuring stocks by market cap is valuable since the smallest stocks have the most upside but tend to be the most volatile and risky.
Examples of Small-Cap Stocks
What are small cap stocks examples? Small-cap stocks with market cap values under $2 billion aren’t hard to find. Some companies go public with a market cap already north of $2 billion, but many tinier firms begin as small-caps before gaining in value through stock price appreciation or issuance of new shares. Small-cap stocks tend to reside in indices like the Russell 2000 or Wilshire 5000 instead of the more concentrated Dow Jones Industrial Average or S&P 500.
One useful example is Rite Aid, a popular drugstore in the United States. Despite its name recognition and actual company size (over 50,000 people work for Rite Aid), the market capitalization of the stock is still under $500 million, putting it firmly in the small-cap camp.
How to Invest in Small-Cap Stocks
So how do you invest in small-cap stock? Here’s a simple four-step guide to building a small-cap stock portfolio.
Step 1: Develop criteria for small-cap investments.
Thousands of stocks can be labeled as small caps, so you’ll need to develop specific criteria for your potential investments. Some investors look for small caps in a specific industry, such as biotech or energy, while others search for metrics like strong sales growth or high-potential products. Develop your own strategy based on your investing goals and needs.
Step 2: Formulate your ideal small-cap portfolio.
Once you’ve developed a strategy, find stocks that fit your criteria for a small-cap portfolio. Small-cap stocks are inherently risky, so a diverse portfolio is a must. But even with a diverse portfolio of companies, small caps can struggle during weak economic conditions or macro events like COVID-19.
Step 3: Use a broker with small cap shares available.
Unlike large-cap stocks, small-cap stocks aren’t as widely traded and not all brokers will be able to locate shares. So do a little research before signing up for a new brokerage account and ensure you find one with access to the specific companies you’re looking to add.
Step 4: Fund your account and purchase shares.
After opening your brokerage account, figure out how much capital you want to devote to small-cap investments. You should have a detailed list of stocks with potential by this step, but determine how much of your money you want to put to work in this volatile market area. Too much concentration in small-cap stocks can lead to serious portfolio declines in poor market conditions.
Best Small-Cap Stocks
Small-cap stocks can produce outstanding returns, but this comes with volatility and risk. Here are a few small companies from MarketBeat’s stock list with potential, but always research before purchasing any stock, especially those of the small-cap variety.
HireRight Holdings Corporation
One of MarketBeat’s top-rated small-cap stocks is Nashville-based HireRight Holdings Corporation (NYSE: HRT), a staffing services firm providing employment compliance solutions to a global array of clients. HireRight handles background checks, drug screenings and ID verification using its own data platform software.
Bloomin’ Brands Inc.
Bloomin’ Brands Inc. (NASDAQ: BLMN) is a small-cap stock that owns and operates four different chain restaurants in the U.S. and abroad. Outback Steakhouse is the most popular chain under its umbrella (notice the name of the holding company), but it also owns Carrabba's Italian Grill, Bonefish Grill and the more upscale steakhouse, Fleming’s Prime. At the start of 2022, Bloomin’ Brands operated over 1,000 restaurants in 17 countries.
BootBarn Holdings Inc.
BootBarn Holdings Inc. (NYSE: BOOT) is a specialty retailer operating over 300 stores across the United States. BootBarn stores sell work-related and western-themed clothing such as footwear (obviously), outerwear, jackets, brightly-colored hunting gear and flame-resistant apparel. Keep an eye on this small-cap stock in the retail sector, with its strong e-commerce footprint and steady sales growth.
Upwork Inc. (NASDAQ: UPWK) was a small-cap darling during the COVID-19 bull market run when freelancing became a popular way to earn income. Upwork connects businesses with professionals through its job marketplace but also offers premium products such as payroll and escrow agency services. Freelancers can work in a wide range of fields, such as writing, sales, graphic design, programming, data science and engineering. Upwork makes it easy for small businesses to outsource difficult work and manage freelancer contracts.
The Hain Celestial Group Inc.
Hain Celestial Group Inc. (NASDAQ: HAIN) sells organic and natural products to various retailers, such as snack foods, natural foods, infant formula and personal care products.
Some of its most popular brands include names like Earth’s Best, Queen Helene, Spectrum Essentials, Avalon Organics and Health Valley. Hain Celestial markets and sells its products through a vast distribution network, including convenience stores, grocery stores, club stores and various e-commerce retailers. Hain Celestial is based in New York and you can find its products in over 80 countries.
Aspen Aerogels Inc.
Aspen Aerogels Inc. (NYSE: ASPN) doesn’t crack the $1 billion market cap mark but that doesn’t make its services any less crucial. Based in Massachusetts, the company sells aerogel insulation products to protect infrastructure from inclement weather, fire and corrosion. Aspen Aerogels has clients on four different continents in industries such as energy storage, power management, refrigeration systems and building materials.
What Should You Look for When Buying Small-Cap Stocks?
If you’re new to investing, you might wonder what features to look for in small-cap stocks. Every investor has different goals, but some factors are helpful across the spectrum. Here are a few key points of emphasis to look out for when researching the best small cap stocks.
- Liquid shares: Small-cap stocks are often thinly traded and large purchases can be difficult if the stock doesn’t have ample liquidity. Make sure your ideal stocks have enough shares readily available for trading. One telltale sign of an illiquid stock is a high bid/ask spread, which is the difference between the buy and sell price of a particular stock. A wide gap in bid/ask spreads is often an indication of stock that would be hard to sell in a drawdown.
- Product or brand recognition: As shown in the Rite Aid example, a small-cap stock doesn’t necessarily need to be new or unknown. Many small-caps have a niche market that works well for them and expansion isn’t on the agenda. Small-cap companies with easily recognized brands or products can benefit investors greatly.
- Low debt: High debt in a small company can be a recipe for quick failure. One of the reasons investing in small-caps is risky is that many companies don’t make it past the small-cap stage; they simply go bankrupt and are forgotten. Debt is a major reason small-caps go under, so make sure your investments have manageable debt burdens.
- Strong leadership: Bad leaders can sink small companies quickly with unnecessary expenditures, poor marketing or ethical missteps. Large-cap companies often have very public CEOs with detailed business histories. Small-cap companies require a little more in-depth research into the management team.
Is Small-Cap Investing for You?
Let’s take a look at the pros and cons of investing in small-cap companies.
Small-cap stocks have a high potential for growth since they’re often newer companies with products yet to be fully embraced by the market. Established companies may not have as much room to run in terms of stock price appreciation, but finding a winner in the small-cap space can produce some seriously outsized returns.
Large-cap stocks often move in lockstep with each other since they’re all part of the major indices like the S&P 500 and NASDAQ. Small-cap stocks offer portfolio diversification since many don’t reside in the same indices as large and mid-cap stocks.
Unfortunately, small-cap stocks have a high rate of failure and many fail to make it long-term. To avoid the risk of bankruptcy or poor performance, don’t devote all your capital to a handful of small caps. Instead, spread the money around so failures don’t sink your entire portfolio.
Small caps are volatile and there’s simply no way to avoid that, even with the most promising firms. If high volatility is something you struggle to deal with as an investor, small-cap stocks might not be the best investments for you. Be prepared for a bumpy ride when buying small-cap companies.
Small-Cap Stocks Carry Risk but Can Offer High Rewards
Small-cap stock investing isn’t for everyone. Many investors prefer the safety and predictability of established companies that have been publicly traded for years or decades (or longer). If you have a high risk tolerance, can withstand volatility and want to reap the rewards beyond traditional investments, small-cap stocks may have a place in your portfolio.
No investment strategy produces 100% winners, especially small-cap stock investing. Here are a few commonly asked questions by investors looking to add small-caps to their portfolios.
Are small-cap stocks a good investment?
Small-cap stocks can be suitable investments since they’re often new companies with plenty of runway for growth. However, small caps are also risky and have a high failure rate. Therefore, the best small-cap investing strategies will involve a diverse portfolio of stocks to mitigate potential failures.
How do I start investing in a small-cap stock?
Investing in small-cap stocks isn’t a difficult process. First, you’ll need to research different companies and find a broker with access to small-cap shares. Once you’ve got an idea about your preferred portfolio, buy the stocks on your list and build a diverse portfolio.
How do I choose a good small-cap stock?
Finding quality small-cap stocks can be tricky since analysts often under-examine these companies. Small-cap stocks are often riskier than large-cap stocks, so be sure to look for stocks with strong brands, minimal debt and ample liquidity for trading. One danger of thinly traded small caps is being unable to sell shares during a breaking news event.