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Candlestick chartThere are different ways to classify stocks but one of the simplest is by market capitalization. Market capitalization means the total dollar market value of a company’s outstanding shares. For example, companies can be categorized as large-cap, mid-cap or small-cap. Beyond those groupings, you might also consider investing in microcap stock. As the name suggests, these are stocks that have a smaller market capitalization than even small-cap tickers, but some can offer the potential to be big winners in a portfolio. If you want hands-on guidance in determining whether to integrate microcaps into your portfolio, consider enlisting the help of a trusted financial advisor.

Microcap Stock, Definition

Microcap stocks, which can also be referred to as penny stocks for their low per-share prices, are generally considered to be companies that have a market capitalization under $300 million. There’s an additional subcategory of microcap stocks called nanocap stocks, which have a market capitalization of less than $50 million.

For comparison’s sake, small-cap stocks have a market capitalization ranging from $300 million to $2 billion. Mid-cap stocks are in the $2 billion to $10 billion range. And large-cap stocks have market capitalizations above $10 billion. Within that group, there’s a smaller subset of mega cap stocks that have market capitalizations exceeding $200 billion.

While microcap stocks are smaller companies, that doesn’t necessarily mean they’re complete unknowns. Eastman Kodak, for example, is a well-known and established brand but because of its market capitalization, it fits into the microcap stock category.

Advantages of Investing in Microcap Stocks

"MARKET CAPITALIZATION"Investing in microcap stocks can offer several advantages if you’re choosing the right companies.

First, smaller companies may have more growth potential than large-caps. It’s possible that you could come across a great microcap stock that’s just beginning its upward trajectory. Over time, that microcap could grow into a mid-cap or large-cap company and as one of the earliest investors, you could reap the benefits of capital appreciation, that is, the increase in the value of your shares.

It’s also possible that you could find microcap stocks that are highly undervalued, which may be attractive if you’re a buy-and-hold investor. This approach involves buying stocks that the market undervalues at a discount and holding them over time. For instance, there are numerous microcap options that sell for pennies per share. Again, the payoff is the potential for share price appreciation if the shares eventually grow by leaps and bounds.

Microcap stocks can often be the dark horses of the stock market, flying under the radar of investors. While they may not get as much attention as larger companies, that can work in their favor. Because microcap companies may have fewer investors, they can focus more on scaling and developing their business models to achieve their goals rather than making tactical moves solely to appease shareholders.

Another positive associated with companies whose market capitalization makes them microcap stocks is that their size can make them more efficient. The larger a company gets, the more operations spread out which can lead to inefficiencies. Since microcap companies may have smaller teams, they may be more streamlined when it comes to management which can help produce better results and minimize wasted time or money.

Do Microcap Stocks Have Downsides?

Investing in any stock is risky, because there are so many factors that can influence which way a stock’s price moves. Microcap stocks, however, can kick risk up a notch for a few reasons.

First, microcap companies tend to be less insulated against stock market volatility due to their size. While a mid- or large-cap company’s share price may be slower to respond to market fluctuations, microcap stocks can be more reactive. Increased trading activity, for example, could cause prices for a microcap stock to decline rapidly which can result in losses for investors.

Liquidity is also a concern with microcap stocks, because, overall, they tend to have less trading volume compared to larger companies. If you’re concerned about being able to liquidate shares when you need to, that could be a mark against investing in microcap stocks.

You’re also less likely to see a dividend payout with a microcap stock, which makes them less than ideal if your portfolio is income-focused. It’s possible the company could offer dividends to investors as it grows, but that requires you to stick with a microcap for the long haul, which may or may not fit into the timeline of your investment strategy.

Finally, microcap stocks may offer less transparency or data for comparison if you’re trying to research them. Newer companies don’t have the lengthier track record of historical performance that’s associated with more established companies. Microcaps may also receive less coverage from investment experts and analysts so you’re largely left to do your own homework in researching them. That, in itself, can up the risk factor if you only have limited information with which to evaluate a microcap stock.

How to Invest in Microcap Stocks

Investor checks her portfolio by looking at digital screensInvesting in microcaps isn’t that different from buying shares of any other stock on an exchange in terms of mechanics. You decide which company to buy and how many shares you want to purchase.

What sets microcap stock investing apart is how you approach the research part of it. When comparing microcap companies, it’s important to look at things like:

  • Daily trading volumes
  • Who’s investing in the company
  • How capital is structured within the company
  • The amount of debt the company’s carrying

It’s also important to consider a company’s long-term potential for growth and how that aligns with what you want to achieve with your investments. Checking things like the company’s quarterly earnings reports, annual reports and reviewing the prospectus can give you more insight into how a microcap company operates, what its goals are for growth and how it plans to achieve them.

The Bottom Line

Investing in microcap stocks can add diversification to your portfolio, but it’s important to keep the risks in mind as well as your goals and investment timeline. Like any other stock, it’s important to stick to the rule of knowing what you own to avoid an investment mismatch.

Tips for Investing

  • Consider talking to a financial advisor about the pros and cons of investing in microcap stocks and whether they could be a good fit for your portfolio. If you don’t have a financial advisor yet, finding one doesn’t have to be difficult. SmartAsset’s financial advisor matching tool can help you connect with a professional advisor locally that’s right for you. If you’re ready, get started now.
  • If you’re not comfortable investing in individual microcap stocks, you could try a microcap equity mutual fund instead. These funds allow you to spread your investment dollars across multiple microcap holdings. If you’re interested in microcap funds, take time to look at the fund’s underlying holdings as well as its performance history. And of course, keep the expense ratio in mind since this determines how much you pay to own the fund each year.

Photo credit: ©iStock.com/MicroStockHub, ©iStock.com/Melpomenem, ©iStock.com/Laurence Dutton

Rebecca Lake Rebecca Lake is a retirement, investing and estate planning expert who has been writing about personal finance for a decade. Her expertise in the finance niche also extends to home buying, credit cards, banking and small business. She's worked directly with several major financial and insurance brands, including Citibank, Discover and AIG and her writing has appeared online at U.S. News and World Report, CreditCards.com and Investopedia. Rebecca is a graduate of the University of South Carolina and she also attended Charleston Southern University as a graduate student. Originally from central Virginia, she now lives on the North Carolina coast along with her two children.
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