How to choose the right small-cap investment
The U.S. Fed has lowered the federal funds rate for the first time since the start of the pandemic, cutting by 0.5 percentage points. Investors had been anticipating a rate cut for several months now: starting in July, they have been rotating into small-cap stocks, which are expected to be a key beneficiary from lower rates.
“Given the valuation discount, [potential] earnings growth and the cyclical nature of the small-cap stocks, the Fed starting to cut this week could very well serve as a catalyst to get investors interested in small-cap companies,” Matthew Palazzolo, a senior investment analyst at Bernstein Private Wealth Management, told MarketWatch before the Fed decision. Small caps could rally 30-50% in the next 6-12 months as the Fed cuts rates, Sean Gallagher, the global head of Lazard’s small-cap equity platform, previously stated.
But what small-cap stocks to invest in?
The easiest approach
JPMorgan has recommended allocating 5–10% of an equity portfolio to small caps, while cautioning that selectivity is key given a wide dispersion in the quality of the underlying companies.
The best approach for a beginner investor is to buy shares of exchange-traded funds (ETFs) that track indexes like the Russell 2000, Russell Microcap, and S&P SmallCap 600, resulting in risk diversification, says Georgiy Timoshin, a financial analyst at Freedom Finance Global.
Timoshin mentions Invesco ETFs, which provide exposure to various economic sectors represented in the S&P 600 small-cap index, such as commodities, tech, industry, health care, energy, utilities, etc.
Liz Ann Sonders, the chief investment strategist at Charles Schwab, recalls that the S&P 600 considers profitability when adding companies, so investors may want to use it as a base when screening for ideas. Eligible for the index are U.S. companies with a public float of at least 10% of their shares outstanding. They must also be profitable in the most recent quarter and over the previous four quarters.
How to pick a company
As cliché as it sounds, investors should look for a company that has the potential to grow into the mid-cap or even large-cap segment, which would mean high returns. They should focus on key financial metrics relevant to a company’s economic niche, compare them with those of competitors, analyze the sector, and consider comparable analysis using multiples, says Timoshin.
The Freedom Finance Global analyst highlights CaliberCos, an asset management company trading with upside of over 390%, and Riley Exploration Permian, an oil and gas company with potential for its share price to more than double.
Investors overlook management quality at their peril, advises online incubator and accelerator Faster Capital. Evaluating the experience, reputation, and track record of the management is essential, Timoshin adds. For example, Chuck Royce, a Wall Street legend and founder of Royce Investment Partners, has mentioned that he likes to buy into companies whose management has been in place five years or more, reports Forbes.
What should investors know about small caps?
Small caps remain the most inefficient, labor-intensive, and exciting segment of the equity markets, with hundreds of companies with little or no analyst coverage, said Royce in an interview with Barron’s.
Faster Capital calls them diamonds in the rough, pointing out that they often operate in niche markets, wield disruptive technologies, and have ambitious growth plans. Investors who discover them in time can reap big rewards. Financial media outlet Benzinga highlights Dave, a fintech company that has soared more than 300% in 2024, and Duolingo, which was part of the Russell 2000 just a year ago but now has a market capitalization over $10 billion, with the stock up about 47%.
What should investors be prepared for?
- Small caps are sensitive to business cycles
Small caps are more sensitive to business cycles—alternating periods of economic expansion and contraction—than large caps, says Timoshin of Freedom Finance Global. This is because, according to him, small caps are focused on domestic demand and have a higher debt-to-income than large caps. Another factor is that they do not have the same access to lending, as the investment research site the Motley Fool notes.
- They are more volatile
Small-cap stocks are volatile. “Their prices can swing widely on news, earnings, or even a CEO’s tweet,” notes Faster Capital.
“If you hear about a stock that doubled in a week… chances are it’s a small cap,” says an analyst at stock analysis site Simply Wall St. The opposite is also possible: drugmaker Athira Pharma lost almost 78% of its market capitalization in September after announcing that its Alzheimer’s treatment was found to be no better than placebo.
- Not every small cap turns into a profitable business
Each year, about a fifth of the Russell 2000 companies leave the index, replaced by new ones, points out Timoshin.
He cautions against “survivorship bias,” whereby investors draw conclusions based on data from companies that have survived and thrived. Equally important insights can come from analyzing companies that cannot compete and are on the verge of failing.
Small-cap companies often have great ideas, but they do not always turn into profitable businesses, notes Simply Wall St in an article on opportunities and risks in the small-cap universe. Where one company succeeds, many others fail. The small-cap universe is “huge” and not “monolithic,” affirms Sonders of Charles Schwab.
- Small-cap stocks have low liquidity
Small-cap stocks typically have low liquidity, which is another risk when trading them, cautions Timoshin. Quotes can swing widely due to low liquidity and trading volumes, Faster Capital points out. For example, in September, the micro-cap Sonendo, whose main product is a dental cleaning system, lost 65% of its market value in just four days, despite no news that would explain the decline. Freedom Finance Global senior analyst Ilya Zubkov thinks the sharp loss could be due to the low liquidity of the stock.
Low liquidity also means it can be hard to sell shares at the desired price on the same day.
- Investors must be patient
It may take smaller companies years to realize their potential. Patience pays off, underscores Faster Capital. For example, it took Geron Corporation nearly a decade to prove that its approach to treating myelodysplastic syndromes worked. Due to safety concerns, trials of the drug were repeatedly suspended, causing Geron stock to plunge. In 2024, the drug was finally approved by regulators, and Geron has more than doubled over the last year.
The stocks doing well for Royce Investment Partners today are those that they have owned for years, Royce told Forbes. The Motley Fool provides another example: investors in the iShares Russell 2000 ETF saw a 344% increase in their investments from 2001 to 2019 (including dividends), versus just 253% for the SPDR S&P 500 ETF.
