Small Cap Outlook: How and Why to Invest in Small Cap Stocks

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How and Why to Invest in Small Cap Stocks

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Small cap stocks have shown some improvements in the last couple of years. This made them become more interesting and appealing to investors. 2018 in particular, has been the year where small company shares have shown the biggest improvement on the market so far.  As a matter of fact, small cap shares, as a group, have increased by 11.4% this year, which is significantly more than an 8.5% increase for large-cap shares. Now, investors are beginning to wonder about the reason behind this increase and will it continue to increase as well.

But, more importantly, investors are asking themselves where they should invest. Besides, what are small cap stocks exactly? As you may already know, small cap refers to small companies whose market value determines their capitalization. In other words, companies whose capitalization is worth between $300 million and $2 billion are considered small cap. What’s more, small caps usually have higher stock prices, but it’s the number of available shares on the market that makes them small in the first place. That being said, here’s how and why to invest in small cap stocks.

What’s in it for the investors?

If you’re wondering why you should invest in small cap stocks when there are so many large companies with greater shares on the market, then you’re probably missing out on the potential that small cap stocks actually have. Individual investors have a greater advantage over the institutional ones when it comes to small cap shares. The main reason is that the institutional investors have a tendency to buy large blocks of shares. For large-stock shares, those are relatively small fractions of a big company.

On the other hand, those blocks are a huge percentage of a small company cap. When large blocks of small cap shares are purchased by institutional investors, they automatically trigger the SEC (Securities and Exchange Commission) filings thus making it a public knowledge which, in turn, inflates the stock price. Whereas, individual investors almost never trigger the SEC filings, because they don’t often buy blocks of shares.

What’s driving the small cap improvements?

There are many factors that are allowing small caps to boast greater advantages and there are also trends on the market that are driving the improvements in small caps as well. For example:

  • Tax reforms – After the “Tax Cuts and Jobs Act” has been signed in the U.S. the taxes went down from 28% for large-cap and 32% for small cap to 21% for each. The greater cut of 11% benefits small caps more, as it enables more benefits, such as reinvestment opportunities, stock buybacks, higher earnings per share and so on.
  • Thin market – Small caps are oftentimes thinly traded, which can prove to be a great opportunity for perceptive investors. When a small company starts to grow and it earns more revenue over time, the general public becomes more aware of its existence and its growth forecasts. That’s when the demand for stocks increases as well. Therefore, when investors start to compete for the limited number of stocks, the price is bound to go up.  
  • Acquisitions and mergers – Large companies oftentimes buy smaller ones to advance on new markets. It’s oftentimes cheaper for large companies to acquire small ones instead of starting a competitive branch from scratch. That and the fact that large companies are willing to pay premium for small successful companies makes small caps a worthy investment.

Where to invest?

The number of small companies on the market continues to increase, as more small caps have sold their shares to the public in 2018. In fact, 127 small companies sold shares, which is a 42.7% increase compared to the same time last year. Investors who are willing to diversify their portfolio with such shares should look for small cap stocks with the highest P/E (Price-to-Earnings) ratio. The main reason is that companies with the highest P/E ratio or negative earners came through as the highest return in the small caps group.

What’s more, to ensure maximum ROI, investors should strongly consider stretching their investments to longer periods. The reason behind this is that small caps can easily outperform large-caps. For example, small caps have increased in value on average by more than 12% annually between 1927 and 2007, while large caps have increased value by 10% during the same time period. It’s estimated that small caps will meet the year’s end with an S&P 600 ratio of 13% to 17%, thus outperforming large-caps.

Another interesting fact is that statistics show that small caps have been up to 100% since 1986 when GDP was around 2% to 3%. It’s estimated that the GDP for 2018 will be in 2% to 3% range, while consensus estimates it to be above 2% in 2019 as well. According to those statistics, when the GDP is within 2% or 3% range, small caps become a profitable investment opportunity.

 

Investors that haven’t considered small cap stocks as part of their portfolio diversification should definitely do so. Small caps are on the rise and they prove to have great potential for a substantial return on investment.

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