If you peruse various financial independence groups on Facebook, Reddit, and other mediums, you’ll find swaths of people who would never recommend anything other than index funds. But if you want to grow your net worth quickly, there’s another asset class you may want to consider: small-cap growth stocks.
Total-market and S&P 500 index funds are perfectly fine, but they won’t necessarily give you the best possible growth. Our mission at Blooming Wealth is to give you the best options to grow your net worth, so today, we’ll take a look at small-cap growth stocks and how they could help you accelerate your net worth.
What Are Small-Cap Stocks?
Small-cap stocks are stocks with a “small” market capitalization. Market capitalization is the total value of all outstanding shares of a company’s stock. A stock is considered “small-cap” if the company’s market capitalization is between $300 million and $2 billion.
While market capitalization is not a perfect measure, it is a rough estimation of the total value of the company.
Because market capitalization represents the total value of a company’s outstanding shares, this means that only publicly-traded companies have a market capitalization. In other words, there are plenty of companies that are smaller than this threshold, so, small-cap companies are still large in the grand scheme of things.
Small-Cap Growth Stocks
So, then, what are small-cap growth stocks? Simply put, these are stocks of small market capitalization companies that are growing.
Why does this matter? Well, if a company is worth $300 million and is growing, it’s not unrealistic to imagine their value doubling in the next decade or two. For you, the investor, that’s huge.
Doubling up your money is nothing to sneeze at. Imagine doing that at the blackjack table! (And no, we don’t encourage gambling here.)
If a company is large cap ($10 billion+), it is much less likely they could double their value in a relatively short period of time.
As we can see, small-cap growth stocks have much greater growth potential than any large cap stocks.
These stocks have a high price-to-earnings ratio, meaning the price you pay for the stock is high relative to how much the company earns. However, these stocks are still attractive because the company is projected to grow quickly, meaning the stock could be a better deal in the future.
Small-Cap Value Stocks
Small-cap value stocks are also small-cap, but the difference is in the company’s price-to-earnings ratio. These stocks have a low price-to-earnings ratio, meaning the price you pay for the stock is low relative to the company’s earnings.
Because the price you pay for the stock is low, these are effectively “discount” stocks. Remember that these companies are still worth at least $300 million, so they’re no mom-and-pop shops.
These companies still have a fairly large amount of assets, but value stocks allow you to buy a piece of the pie at a relatively low price.
And because small-cap value stocks have relatively high earnings, the return you get as a shareholder is excellent as well.
To look at some real data, the 10-year return on Vanguard’s small-cap Value Institutional (VSIIX) fund currently beats the benchmark by over 3%. These percentages change often, but there is a wealth of data that shows small-cap value funds outperforming the market.
For example, if we look at the much larger picture, the 90-year return on the S&P 500 is 10.2%, while the return for the small-cap value index is 13.2%. Again, around a 3% difference!
For those who are new to investing, 3% doesn’t sound like much. But if you already have a baseline knowledge of investing, you know how powerful a 3% difference can be.
Small-Cap Blend Funds
A small-cap blend is not a stock, but, rather, a fund. Blend funds include both value and growth funds. It is also possible to have a large cap value fund, though in this article we are focusing on small-cap.
What is the benefit of a small-cap blend fund? Essentially, it makes your portfolio less one-dimensional. Both value and growth funds have something good going for them.
Value stocks have a low price-to-earnings ratio, but they may not be growing as fast as growth stocks. However, growth stocks have high price-to-earnings ratios, meaning you get less for your money (at least for now).
By investing in a blend fund, you get both the growth as well as the value of both types of stocks.
When Do Small-Cap Stocks Perform Best?
Small-cap stocks tend to perform the best when rates are increasing. This usually happens at the beginning of an economic recovery as the Fed looks to bolster the economy.
However, you should exercise caution if you intend to employ this type of strategy. Doing so is flirting with market timing, which is something I never recommend.
A safer strategy is to invest in small-cap funds early in your career; that way, you will reap the benefits of small-cap stocks while still having more than enough time to recover from any volatility they may cause.
The (Potential) Downside of Small-Cap Stocks
Small-cap stocks have the potential to catapult your portfolio and help you grow your net worth much more quickly than you otherwise would.
But, as we discuss throughout our articles, your money grows when you invest because you are accepting a certain level of risk. In addition, stocks can be volatile compared to other forms of investment, such as bonds.
But recall that small-cap stocks are stocks issued by small, and sometimes growing companies. Many companies experience growing pains – even if the company has a successful business model.
The result is that small-cap stocks can indeed be more volatile at times than large cap stocks. I have looked over the data to find that sometimes their returns are worse than the S&P 500.
That being said, although small-cap stocks can experience worse returns than the S&P 500 at times, the performance degradation is usually modest. In contrast, when small-cap stocks outperform the S&P, they destroy it.
One example of this is to look at the stock market from 1928 to 2018. The best 1-year return the S&P 500 saw during that time period was 54.0%. That’s pretty good – until you find out the best 1-year return for small-cap value during the same time period.
During that time, the best 1-year return on small-cap value stocks was a whopping 125.2%.
So while there may be slightly more volatility at times, sometimes you do have to take some risks to be rewarded.
Are small-Cap Stocks a Good Investment?
Small-cap stocks are a great investment! In general, we would recommend a diversified portfolio. I would recommend looking over Paul Merriman’s portfolios – I have to give Paul credit because he was the one whose content first brought me up to speed on them.
You’ll notice that some of his portfolios are entirely small-cap, while others have more total-market exposure. Paul has done decades of research on this to find that small-cap stocks are generally a good investment, but you should take your risk tolerance into consideration.
If you are particularly risk-averse, you may want to consider a more diversified portfolio that includes total-market funds such as VTSAX.
What Are the Best Small-Cap Stocks to Buy?
My recommendation is not to buy individual small-cap stocks, but to buy small-cap funds instead. Again, you can reference Paul’s list above for this.
One of the benefits of funds is that they are inherently diverse compared to individual stocks. Even if one or two companies goes under, you will be invested in dozens, if not hundreds of other companies.
The best place to buy those funds is wherever your prefer. If you decide to invest in one of Paul’s all-ETF funds, you can buy those almost anywhere. That includes apps such as M1 Finance and Robinhood.
Or, you could decide to invest in one of his Vanguard or Fidelity portfolios. Even if you are limiting yourself to ETFs and mutual funds, the possibilities are almost endless.
As long as you have a good bit of small-cap exposure, though, you are employing the small-cap strategy to some degree.
Don’t Forget the Investing Basics
I always advocate for a simple investing strategy, and small-cap stocks don’t change that. Although small-cap stocks can make your returns better, don’t get too caught up in fractions of a percent – and don’t spend all your time trying to time the market.
Instead, set your portfolio up in a way that it can grow, but don’t worry about it too much. For many investors, the worst possible course of action is to pay too much attention to their portfolios. Why? Because they see their portfolio dip a bit, panic, and pull all their money out.
This is never a good strategy. Pick a portfolio that works for you, and stick to it.