Small-cap stocks can be a popular destination for risk-seeking investors. These small businesses have to overcome a lot of challenges and hurdles that don’t always succeed. Yet, for the few that make it, enormous returns can be unlocked within an investment portfolio.

To be a successful small-cap investor requires a strong stomach for volatility, along with plenty of due diligence & research. With that said, let’s explore this area of the stock market in more detail.

What are small-cap stocks? 

Small-cap stocks are any publically traded company whose market capitalisation lies between £200m and £2bn. They can be found in almost every industry and sub-sector.

As previously mentioned, these small-scale businesses often have much to prove. And with so much of their share price tied up with investor expectations, the stock price can often be volatile.

When good news comes out or earnings are ahead of guidance, it’s not surprising to see small-cap stocks surge by double-digits. However, this also works in reverse. If earnings miss the mark, a sudden drop can quickly follow.

While this volatility can create buying opportunities for patient investors, there is no guarantee of long-term recovery. That’s why it’s critical to determine whether the drivers behind positive or negative share price movements are temporary or permanent.

Historically, small-cap stocks have vastly outperformed large-cap blue chips in terms of growth. This is why some investors are willing to expose themselves to this stock market segment despite the increased level of risk.

What are the benefits of investing in small-cap companies?

The growth potential of small-cap stocks is often understated. While the odds are thin, investing in these types of shares opens the door to multi-bagger returns than large caps typically can’t provide.

Don’t forget companies like Amazon and Microsoft were all small-cap stocks at one point in their history. And an early investment into these businesses would have sent even a small investor into millionaire territory.

In retrospect, it’s easy to say that these companies were no-brainer investments. But at the time, it was pretty challenging to know. Even today, when we have vastly more access to information and analysis, it’s incredibly tough to find the next Amazon or Microsoft.

It’s also worth noting that the small-cap space often gets targeted by merger and acquisition firms. In fact, there are investment strategies that revolve around investing in businesses likely to be acquired in the near future. And since these types of deals can carry lofty premiums on valuation, correctly predicting these decisions can be highly lucrative.

For instance, Take-Two acquired Zynga earlier this year for a value of $12.7bn, at a 64% premium to Zynga’s share price at the time.

Are small-cap stocks risky?

Yes. I’ve already eluded to the increased volatility. But even ignoring this as a long-term investor, small-cap stocks still have plenty of other threats to contend with.

Small businesses can be highly susceptible to economic factors such as rising inflation and recessions. Furthermore, many are unprofitable enterprises. As such, they remain dependent on external capital through equity or debt, making rising interest rates a big problem.

Suppose access to external capital gets shut off or is too expensive, and the firm’s internal cash flow is insufficient to keep operations going. In that case, a stock bankruptcy can often be just around the corner. In other words, the odds of a small-cap stock going to zero are much higher than a more established business.

Something else to consider is trading volume. Because of their small size, institutional investors are rarely interested in this space. Consequently, the trading volume of a small-cap stock can be low, making it difficult to match buyers and sellers. This can make it difficult to buy or sell shares at a later date without a wide bid-ask spread that can negatively impact returns.

Another factor to be weary of is dividends. While rare, some small-cap stocks offer dividends to shareholders. But with heavy levels of re-investment required, these dividend payments are usually unreliable and can add even further volatility to the stock price if and when they are cut or suspended.

Here’s how I’d pick a good small-cap company

When it comes to picking high-quality small-cap stocks, investors need to be cautious not to fall into a momentum trap.

A good story can often lead people astray and ignore glaring problems with the underlying business. That’s why researching the bull and bear case before making an investment decision is paramount, even more so than when investing in a large-cap company.

While some factors are ultimately unpredictable, careful research can frequently highlight red flags even in the most promising of businesses.

With that said, here are some critical things I like to check before making a small-cap investment:

• Is the company operating in a growth sector or industry?
• Does the business have a robust balance sheet with plenty of liquidity?
• Is the company overleveraged with debt or other loan instruments?
• How skilled is the management team at capital allocation, and what is their background experience?
• What is the level of insider and institutional ownership?

This is by no means a conclusive checklist. But it can help eliminate a lot of duds from consideration.

Should I invest in small-cap stocks?

Historically small-cap shares have outperformed the general stock market. But as exciting as that prospect is, it’s critical to remember that for every Amazon, there are hundreds of other companies that failed to survive.

This is a risky space to invest in. And subsequently, that means it’s not suitable for everyone. Small-cap stocks are likely a good place to be for those willing to take on substantial risk to pursue potentially massive long-term returns. But for investors seeking to protect wealth or keep risk to a minimum, investing in mid-cap or large-cap stocks is likely the more prudent course of action.

At the end of the day, deciding whether or not to invest in small-cap stocks is a personal decision.

Prosper Ambaka does not own shares in any of the companies mentioned. The Money Cog has no position in any of the companies mentioned. Views expressed on the companies and assets mentioned in this article are those of the writer and therefore may differ from the opinions of analysts in The Money Cog Premium services.