Therefore, investors should ask themselves what their risk tolerance and time horizon are. It can be difficult to gauge optionality, but a look at a firm's operating history and industry should offer some hints.Ĭompared to larger stocks, small-cap investing offers greater risks but also increased return potential. Amazon's move into cloud computing is an example. Optionality: Optionality is the potential of companies to break into new business lines.Is this company trying to disrupt a market worth tens of billions of dollars or even hundreds of billions, or does it have relatively little room for growth? A large TAM and high revenue growth can be an especially rewarding combination for a small-cap stock. Total addressable market (TAM): Since you're looking for small-cap stocks that can eventually become large-cap stocks, you'll want to consider the size of the opportunity the company is chasing.So it's important to look for stocks that have a track record of growth, especially at the small-cap level, as this momentum can build for several years to come. They don't just take off after several years of trading sideways. Past price appreciation: The best-performing stocks tend to have a history of outperformance.However, price-to-sales ratios vary widely from industry to industry, so drawing apples-to-apples comparisons is particularly important. Lower ratios generally reflect undervalued companies on a relative basis. Price-to-sales (P/S) ratio: The P/S ratio is a company's market capitalization divided by its revenue, which can be a useful metric for companies that don't have earnings.A lower ratio may indicate a company is a bargain, while a higher ratio may suggest it's too pricey. Price-to-earnings (P/E) ratio: This metric is useful for determining if companies with earnings (remember, some companies have negative earnings) are relatively overvalued or undervalued.Small-cap growth stocks may not have profits, but ideally net income will be trending upward to narrow losses. For mature companies, you'll want to see earnings growing at least as fast as revenue. Earnings growth: Earnings growth is less important than revenue growth for small-cap stocks, but it's still worth considering.A deceleration in the top line can indicate that the business is either maturing or potentially failing. If you're looking for a small-cap growth stock, revenue growth over 20% is ideal, as well as a track record of steady revenue growth. Revenue growth: Sales growth is particularly important for small-cap stocks because younger companies should be able to deliver higher revenue growth than larger, more mature companies.Below are a few metrics to keep an eye on. While there are plenty of small-cap value and dividend stocks out there, the reason to buy small-cap stocks is their growth potential. What should you look for when buying a small-cap stock? On the other hand, successful small-cap stocks graduate to mid-cap or large-cap levels, and former small caps like Amazon have delivered returns of 100 times or more. From 2001-2019, investors in the iShares Russell 2000 ETF have seen their money grow, including dividends, by 344%, while investors in the SPDR S&P 500 ETF have seen their money grow by just 253%. That's why the small-cap index Russell 2000 has historically outperformed the S&P 500. It's much easier for a $1 billion company to become a $2 billion company, for example, than it is for a $1 trillion business to double to a $2 trillion value. Investors often consider investing in small-cap stocks because they have historically produced greater annual returns than the mid-cap and large-cap stocks in the S&P 500 index.īy definition, small-cap stocks have greater opportunity for growth than their large-cap partners, as the law of large numbers means it gets more difficult for companies to grow as they get bigger.
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