What is the Small Cap Effect?

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Choosing which stocks are worth investing in can be a challenge, even for the most experienced investors.

It’s a constant battle over how valuable a stock is and how likely it will grow in the future. Due to the volatile nature of the stock market, investors certainly have their work cut out for them.

Some investors find that investing in small-cap stocks is simply not worth the time and effort. A small-cap stock investment comes with its fair share of risks, as all stocks do.

However, it’s worth considering some of the advantages of investing in small caps, as their growth potential can be quite attractive.

Let’s explore the meaning of the small-cap effect, some examples of small-cap stocks you can invest in this month and some of the benefits and drawbacks of small-cap stock investments.

The Small-Cap Effect: Fact or Myth?

There’s some debate over whether or not the small-cap effect has any viability to it. However, over the years, expert analysts of the stock market have come up with new research that suggests the small-cap effect is alive and real. So, what is it?

Essentially, the small-cap effect describes the concept that small companies with a small market capitalization tend to experience more growth than their larger counterparts. The argument lies in the idea that small-cap companies tend to be more nimble, making it easier for them to grow.

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This is critical to consider as an investor — the ultimate goal for anyone investing in stocks knows that companies with potential growth have real value.

According to this research, the 10% of small caps in the S&P 500 have outperformed the largest 10% by 1.2 annualized points.

One of the noted reasons why this is a direct result of the growth of index funds in the market, specifically the index funds benchmarked to the S&P 500.

There’s evidence that large-cap stocks have become overvalued, giving small-cap stocks an advantage. The widening spread of overvaluations allows smaller companies to outperform larger ones.

While there’s still debate about whether the small-cap effect is worth looking into, there are some advantages to investing in small-cap stocks.

Before investing, it’s always key to reach out to financial professionals who can assist with tax payments, which can easily become overwhelming if you’re an avid investor.

Let’s look at some potential small-cap stocks that may be worth investing in this month.

Examples of Small-Cap Stocks

Publicly traded companies with a market capitalization of less than $2 billion are considered small-cap companies. These could be startup companies or young companies with high-growth potential.

Here are some examples of small-cap stocks that you may want to consider investing in:

 

  • Encore Wire Corp. (WIRE)
  • California Resources Corp. (CRC)
  • Cassava Sciences Inc. (SAVA)
  • Primoris Services (PRIM)
  • EnPro Industries (NPO)
  • Brightcove (BCOV)

While there are plenty of other small-cap stocks on the market, let’s first go over some benefits and drawbacks of small-cap stock investments.

Benefits and Drawbacks of Investing in Small-Cap Stocks

Below are some considerations to make if you want to try investing in small-cap stocks. It’s always vital that investors think about all the contributing factors before deciding to invest.

Benefits

Growth potential is a clear indication that small-cap stocks may be worth investing in. Because they’re smaller in size and scale, smaller companies naturally have more room to grow compared to larger companies.

There are some inefficiencies when it comes to pricing small-cap stocks. Small-cap stocks are typically neglected, leading to improper pricing. Investors can take advantage of this opportunity and pay less while earning a greater return later on.

Lastly, small-cap stocks are not usually invested in by financial institutions if they’re complying with regulations. It’s unlikely that small-cap stock prices will be artificially raised, unlike large-cap stocks.

Now, let’s examine some of the drawbacks.

Drawbacks

Investing in small-cap stocks comes with higher risk because smaller companies tend to have unreliable business models, leading to poor financial performance.

Illiquidity plays an important role in small companies. Stocks may become unavailable or challenging to sell at a favorable price.

Compared to large companies, investing in small companies is a time-consuming activity. It takes ample time to research if small companies are worth investing in because there’s limited information on them.

Taking all of this into consideration is vital for any investor. However, by investing in small-cap stocks, you could benefit from a greater return than large-cap stocks. It’s all reliant on the market itself and how small companies perform.

Consider Small Caps in September

Small-cap stock investments could be a perfect way to diversify your investment portfolio. Based on your prior investment knowledge and the benefits and drawbacks listed above, you’ll know if it’s right for you to invest in small-cap stocks this September.

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