Investments

Small Cap Investing: Risk v. Reward

Posted by MoneyController on 11.02.2021

Small cap stocks (market cap: $0.25 - $2 billion) generally carry a bad reputation. Their negative news usually receives more attention from the media, resulting in the perception that they are too risky. They are also considered to be lacking in quality management and hence prone to fraud.

But the above concerns hold true for any company, irrespective of its size. Enron is an example. Its investors lost nearly $74 billion while its employees lost their pension benefits. The company itself ended up declaring bankruptcy. At the end of the day, it is up to the investor what risks he or she wants to take. Let’s take a look at some of the factors that can help the investor make the right decisions.

Growth Potential

Most of the large cap companies that exist today started out as small cap companies. Anyone wanting to make serious money from a small investment would want to catch these companies at this stage. A small investment at this point has the potential to turn into a fortune. With the way social media communities are becoming increasingly active in the stock market, more and more investors are getting their hands-on small cap growth companies. One recent example is Organigram Holdings, a cannabis company that has seen an increase of 150% within 3 days. Its market cap currently stands at just over $1.75 billion.

Acquisition targets

Small cap companies sometimes create unique products that become highly valuable for large cap companies, making them an ideal candidate for acquisition. An example of this was seen with Maxwell technologies. The company was working on ‘dry electrode technology’. Tesla saw the potential in the company’s technology and decided to buy out the whole company. At the time of its byout, the company’s market cap was just over $200 million. But those who had invested in the company early had already reaped a great reward on their investment.

Getting in at the right time

Most funds aren’t able to buy a stake in small caps because of the regulations controlling how much of a company they can buy a stake in. For funds to take up a sizable stake in a small cap, they would have to own a large part of the company, which isn’t considered a fair market practice in the eyes of the regulators. This means that the share price of small caps isn’t driven up by large institutions buying their shares. Hence, you’re quite likely to establish your position in a small cap at reasonable prices.

Risk

We’ve already determined that the reward potential in small caps can be immense. However, that potential comes at a price, and that price is paid in terms of risk. Small caps not only need to be profitable, but they also be able to scale their business for future growth. That is not always possible, no matter how successful a company has been on a smaller scale.

To add to this, small caps tend to be more volatile, less liquid, and demand a lot of time investment and research. The usual fundamental analysis metrics may not be as useful as knowledge of the industry and future potential of the company’s products. Those who can see the use of a company’s unique product in the future can reap high rewards by becoming early investors.

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