Small and Micro-Cap Stock Investing – Definition, Benefits and Risks
These days it seems like everyone has their favorite investment style. Nowhere is this clearer than Wall Street itself. Everywhere you turn, another investment advisor or investment fund is busy devising a new magic formula for returns on the market. Are they all delivering on their promises? Not even close. 66% of actively traded funds fail to beat the market in a period of more than 5 years, according to Time Magazine. When you consider the costs and selling costs of these advisers and investment funds, it is safe to say that the percentage of funds that do not outperform the market is even higher.
So what is an investor to do? If the goal is for a stable return, there are two options. The first is to invest in low-cost index ETFs, which, by keeping costs down and simulating market indices, often outperform most investment funds. This is probably the best and safest option for many investors. The second strategy is to invest in long-established, dividend-paying ‘blue chip’ shares with a history of increasing dividend payments. These shares generally offer stable returns and also show low volatility.
But what if you are an investor looking for significant outperformance in the market? Depending on your age, risk tolerance and asset allocation, you may be looking for a stock or group of shares with the potential for explosive returns. In that case, investing in index ETFs and blue chip stocks should only be part of your portfolio. In addition, you should consider a generally overlooked group of stocks that can offer such a boost to your portfolio: small and micro-cap stocks.
What are small and micro cap stocks?
Small and micro-cap shares are shares with small market capitalizations.
In general, listed companies with a value of less than $ 2 billion are considered to be small cap stocks, while companies with a value between $ 25 million and $ 300 million dollars are considered micro-cap shares.
Benefits of Small and Micro-Cap Stock Investing
Small and micro-cap equity investments offer some real benefits for investors who are looking for better market performance.
1. Unlimited growth potential
Some of the best known companies in the world started out as small and micro-cap companies whose shares suffered due to the lack of coverage and visibility in the markets. Many of these companies have become Wall Street titans or to dominate their industry niche. Finding a company like this in its infancy is one of the biggest potential benefits of investing in stocks with a small or micro cap. It only takes one small company to grow into a leader in the sector to provide your portfolio with a smashing return.
2. Potential for undervaluation
Everyone wants to invest like a young Warren Buffett and put companies on the map if they are undervalued by the market. On the basis of the efficient market hypothesis, which states that shares are always reasonably valued by the market, this should in theory be impossible. Fortunately, this is not the case with investing in small and micro caps. Because small and micro-cap companies are relatively unknown and generally do little or no research into shares, they can often be bought up with a significant discount on their intrinsic value. Do your due diligence with the company and you could have a big lead over other investors.
3. Prime Acquisition Targets
Just because small and micro-caps are not yet known to Wall Street traders, this does not mean that they are not noticed by the leaders of their industries. Many small and micro caps never become large multinationals because they are eventually taken over by their larger competitors. As an investor, this is just like winning the jackpot, as acquisition premiums can often offer many multiples of the company’s current stock price.
4. Long-term durability
Because the majority of small and micro-cap companies do not have the full attention of Wall Street, they do not have to be as concerned as their large-cap counterparts about sacrificing investors in the long term to meet the short-term investor expectations. As a result, these companies often focus on their long-term health and create an efficient company that is sustainable and has significant growth potential.
5. Efficient, focused companies
Small and micro-cap companies have an extremely focused business model because of their size and, often, young age. Most of them have never made an acquisition and have not had the opportunity to expand the breadth of their business. For example, small and micro-cap companies are focused and operate extremely efficiently. This characteristic is one reason why they can serve as attractive acquisition objectives; they boast industry knowledge and thanks to their focused business model they can more easily be placed under the umbrella of a larger company.
Risks and disadvantages of Small Cap Stock Investing
Although shares in small and micro caps seem like a good thing if you find the right company like any other Wall Street investment, there are risks.
1. No dividends
Because most small and micro-cap stocks are such fast growers, they usually retain all their profits and reinvest in the growth of the company. While this is good for the future of the company, it also means that investors continue to count on capital growth as the only source of potential upside potential.
2. Less coverage by analysts
Let’s be honest. For most of us, a company’s balance sheet is pretty intimidating, and it is often reassuring to read an analyst’s report about a company’s potential before making important investment decisions. This is often not the case with shares in small and micro caps. So, if you want to go this route, make sure that you can read a quarterly report and balance sheet without having to rely on coverage from heavy analysts to indicate the overall health of the company.
3. Low liquidity
Although this is not usually the case for small caps, many micro-cap companies are extremely thinly traded. As a result, investors will be faced with significant Bidette ask spreads when they try to buy or sell the shares. It can also sometimes take days, weeks or months to build up a significant position in the company because of this low liquidity. In general, liquidity is not a problem with small-cap shares because there is enough coverage and interest in the company to promote a healthy trading environment.
4. Market fluctuations
Usually due to liquidity issues, many of these smaller companies can be extremely volatile. Sometimes a buyer or a seller who trades several hundred shares is all that is needed to increase the share price at Gryetteijk. Be prepared for large movements both up and down, especially with micro-cap companies.
5. Prime Acquisition Targets
You will notice that this point is also mentioned as a pro. This is because when you find a solid company with excellent growth prospects and a potential for future market dominance, often the last thing you want is that the train is derailed by a business takeover. Of course you will get a nice penny for your stock shares in the short term, but a long-term investor will probably feel a sense of sadness because their stock investment no longer offers the enormous upside potential it has ever known.
As you can see, investing stocks with a small and micro-cap potential offers a significant advantage. It is perhaps the ticket for turbo charging your portfolio for future growth. But before you start evaluating companies with market capitalization below the $ 2 billion threshold, it’s important to also understand the risks of investing in small caps.
For less advanced investors, investing in small and micro caps should make up a smaller portion of your portfolio due to inherent risks and volatility. Also make sure you perform your due diligence before you invest in one of these companies.
Have you invested in small or micro-cap companies? If so, do you have any other advantages or disadvantages to add to the mix?
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