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Small-Cap Stocks: The Beginning of the Journey

Posted on September 23, 2020 by Todd Marvel

Once an individual investor wants to roll up his sleeves and do some research in the pursuit of the upcoming big winner in the stock exchange, the place many start is in the small cap sector.

Much like the other capitulation dimensions (capitalization is a stock's market value), nobody can completely agree on a precise definition, but corporations under $2 billion are usually considered small caps. It needs to be pointed out that there are two asset classes below little caps. Micro caps are businesses between $50- 300 million and Nano caps are under $50 million. To further confuse the issue, there are also"penny stocks" that actually have nothing to do with capitalization size, but are stocks that trade quite cheaply.

Life starts for many tiny caps as an Initial Public Offering (IPO) or as a"spin off" from a larger firm. Like Toddlers, these businesses are often still in their developmental phase. At this time they exhibit characteristics that provide them the possibility of both gigantic growth and intense downside volatility.

Their massive expansion potential is obviously the piece that brings most investors. Who would not have wanted to invest in on a Microsoft in its first days of trading? The question of course is who knew about Microsoft back then?

Frequently, it is people not institutions that get in on the ground floor. Analysts working for major brokerage firms typically don't have enough opportunity to develop policy on small businesses and institutional investors generally have limits of just how much they could own of one business. Though a $100 million might seem a lot to an individual, it is a drop in the bucket for the big players and equals 20 percent of a $500 million business. The 20% far exceeds what the SEC stipulates a mutual fund can own and frequently exceeds the investment policy statement of an institutional investor.

The drawback here to the investor is that there is relatively little published research which the individual may depend on in the decision making process. But the great thing is that the individual investor has the opportunity to buy the stock before the associations get in and run the cost up.

Many investors believe in the"efficacy" of the marketplace. This implies that with all of the information out on a specific stock, the market can"effectively price" any inventory. In the case of small caps (where data is often lacking), an argument could be made that there's some possibility to benefit from inefficiencies in the industry. Again, this cuts two ways. Many investors can remember it was not too long ago that many small cap techs sold for vastly inflated prices simply to watch a steep cost slide as the market began to correct these inefficiencies.

Income investors should probably look elsewhere. Small caps generally conserve whatever money they earn for expansion potential. Any return is generally incidental to their objective.

For mutual fund investors, small caps may be an interesting suggestion. Surely, mutual funds can help offset some volatility through diversification. However, for investors looking to stick to a little cap's ascension into the large cap sector, mutual funds may disappoint. Often, to avoid what is called"style drift" a mutual fund manager sells a prosperous position only because it has outgrown its capitalization value. While this might be helpful for asset allocation purposes, it is not attractive for investors wanting to see a company "develop".