When most investors begin looking for a new stock, the hunt usually starts and ends with a large-cap name valued at more than $10 billion. Although there are many good reasons to own large-cap stocks, it's also a good idea to seek out small-cap stocks -- those with a market cap of between $300 million and $2 billion.
As a group, these companies are much smaller than their larger-cap counterparts, so they have greater growth potential. Under the right circumstances, small caps are a good bet to outperform their larger peers.
Maximize returns
Small-cap stocks have the potential to maximize returns
The best reason to invest in small-cap stocks is their greater potential to deliver outsize returns compared to larger companies. For instance, it's considerably easier for a $1 billion company to become a $10 billion one than for a $100 billion company to grow to $1 trillion.
In fact, some of the biggest companies in the world once traded in the small-cap range, including Amazon (AMZN 1.34%) and Netflix (NFLX 0.78%). If you had bought and held these stocks when they were small, you would have seen your initial investment appreciate more than 100 times.
Small-cap stocks tend to have higher growth rates. Again, it's easier for a smaller company to double its revenue, and mature companies tend to see slowing revenue growth. However, small caps are also more likely to be unprofitable.
This makes them more volatile than large caps because they are more vulnerable to recessions, market crashes, and other shocks. For example, during the 2020 crash when the COVID-19 pandemic hit the U.S., small-cap stocks fell more than their large-cap peers. After rebounding faster, small caps then fell further in the 2022 bear market.
Small-cap stocks are also followed by fewer investors and Wall Street analysts. So, they often have bigger swings on news, such as earnings reports.
Beat large caps
How small-cap stocks can outperform large-cap stocks
Due to their higher volatility, small-cap stocks tend to outperform during young bull markets when stocks are quickly moving higher. For example, after the pandemic-driven market crash in 2020, the Russell 2000 overtook the S&P 500 by the end.
However, you'll notice that since the bear market in the Russell 2000 began on Nov. 8, 2021, the small-cap index has underperformed its large-cap peer, showing how volatility swings both ways.
What's also notable about that chart is that the Russell 2000 index has failed to make its characteristic recovery in the bull market that began in 2023. That seems to be because artificial intelligence (AI)-related technology has driven the new bull market, and large-cap stocks have been the early beneficiaries of AI. Also, high interest rates have pressured small-cap stocks more than their large-cap peers.
By contrast, in the heady days of the bull market following the 2008-2009 financial crisis, the Russell 2000 outperformed the S&P 500 by a wide margin. The chart below shows the first year of that bull market.
In fact, the Russell 2000 outperformed the S&P 500 for most of the decade after the financial crisis. Smaller companies also benefit from accommodative monetary policies, such as low interest rates, which make it easier for them to borrow to expand or keep their businesses afloat during tough times. That could give small caps an edge since interest rates are now expected to fall.
Similarly, fiscal stimulus programs are also beneficial for small-cap stocks since those companies are generally more sensitive to consumer spending and market sentiment. On average, small-caps have an advantage when the U.S. economy is in recovery mode.
It's typically a great time to invest in small-cap stocks when the economy is rebounding, unemployment rates are decreasing quickly, and businesses are seeing strong earnings growth. Of course, small-cap stocks don't always outperform.
Just as these stocks have more upside potential, there's also substantial downside risk since they're less likely to be profitable and can more easily be pushed into bankruptcy. That makes small-cap stocks riskier than blue chip stocks. But with greater risk comes greater potential for reward.
A number of high-growth stocks skyrocketed in 2020 and 2021 before collapsing in 2022 as investor sentiment shifted to become more cautious. Many of those stocks were revealed to be overvalued.
One example is Roku (NASDAQ:ROKU), the leading streaming distribution platform. Roku isn't a small-cap stock, but its valuation is less than $10 billion, and it typifies the challenges facing small caps. It's still delivering solid growth, but it's unprofitable and doesn't have a clear path to profitability.
Lower interest rates could benefit the company by encouraging consumer spending and increasing investor sentiment toward such growth stocks. In a bear market, investors often lose patience for these kinds of stocks, and small caps tend to underperform because more of them are unprofitable.
Recovery?
When will small caps recover?
Nobody knows for sure when small caps will recover and narrow the gap with the S&P 500, but lower interest rates could spark that movement. As you can see in the chart above, we saw a brief preview of this in July 2024 when small caps popped while the S&P 500 fell.
That move didn't hold, but it seemed to be driven by investor rotation in preparation for an interest rate cut. As the Federal Reserve cuts rates, we could see that rotation play out again.
Be smart when investing in small-cap stocks
There are no absolute rules in investing. Although small caps historically outperform large-cap stocks in bull markets, that doesn't necessarily mean your portfolio should consist only of small companies. As always, a healthy balance of different types of stocks is the key.
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You can also look to index funds and mutual funds to make diversification easier. It's important to focus on quality rather than just market cap -- it's much better to own a high-quality, large-cap stock than a low-quality, small-cap stock.
Still, scaling up your exposure to small-cap stocks as a group is historically a winning way to increase your returns. If you can buy some of the top small-cap stocks early in a bull market, you're likely to outperform the market over the coming years and into the long term.
