What Are Small

Small-cap stocks are those of public companies that are $300 million to $2 billion in market capitalization, commonly called market cap—the share price times the number of outstanding shares.

Compared to stock categories like mid-caps and large-caps, these corporations are tiny. Mid-caps come in with market caps of $2 billion to $10 billion. Large-caps are the giants and sometimes behemoths that are $10 billion and up in size. Apple is at the top of the U.S. heap, at more than $2.7 trillion. Then again, when it first went public, Apple was technically a small-cap by these current definitions.

While smaller, though, there are a lot more of them. The Russell 2000 index is a group of roughly 2000 small-cap corporations. Small-caps outnumber the mid- and large-caps put together.

One way small-caps stand out from mid- and large-caps is by their potential. A relatively unknown can grow to be a stalwart. That may be the biggest draw, the hope that you buy an Apple or Walmart WMT , which respectively cost $22 and $16.50 a share, when they are nobodies and then ride growth to huge returns. The reason that is sometimes possible is the magic of volatility, or how much financial performance and stock prices can change. Big swings can make for large success.

"If you invested $1 at the end of 1925 in [an index, or broad collection, of] large-cap stocks, at the end of 2022, you’d have $11,535," says Robert Johnson, chairman, CEO, and co-founder of Economic Index Associates. "If you had done the same with small caps, you’d have $49,052."

Before you say, "Sign me up," wait for the rest of the story. There's no guarantee that outrageous growth will be the reward for investment. If that were the case, the S&P list of the biggest public companies would include thousands, not 500. If you chose a few small caps over the short run, you might lose your shirt.

"Small caps aren't for the faint of heart," Johnson says. "They’re riskier." All because of the same volatility that lets them grow. Jumping into some basis statistics for a second, a collection of values will have a standard deviation, a calculation of how spread out the figures are. A rough rule-of-thumb is that 68% of values will be within one standard deviation.

Large cap stock performances have a standard deviation of 19.8 percentage points, looking at stock histories from 1926 to 2022. If you take the average return, then just over two-thirds of the companies will be within 19.8 percentage points less and 19.8 more.

"Small cap stocks have had a standard deviation of 31.2%," Johnson says. Company performances can swing wildly. That's great when you benefit and not when you don't. What could make you a big winner can also become a huge loser.

There is no guarantee that small-caps outperform large-caps at every time. But sometimes they will, like the period from 2000 to 2009, often called the Lost decade. Large-caps saw a -.9% compound return over the period. Small-caps were up 6.3% on average.

A second aspect of small-caps is also both a positive and a negative. Big investors and analysts tend to look at large-cap and even mid-cap companies because it can be easier and less risky to place large sums of money into large-caps or even mid-caps. Also, there are fewer companies to track, meaning investors and analysts can concentrate their attention. Large-caps and mid-caps are where most of the research is done so you can get insight into company performance. That means you have more work to do. because less has been done already by others. The volatility also makes it harder to model earnings. While you don't have everyone jumping on the same well-publicized opportunities, finding the good ones among small-caps can be a challenge.

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You’ll need a brokerage account, which is an account with a company that can process your trades in stocks, bonds, exchange traded funds (ETFs) and mutual funds. The firm conductors the transactions you want and holds the securities for you.

Many with zero fees for trades and no minimum deposit needed—and from big names in financial services, so probably not disappearing in the middle of the night. There are taxable accounts, in which you pay taxes on money you make, and also retirement accounts that can postpone taxes and which also may have limits on your contributions to it, but those vary significantly by the type of retirement account.

There are also cash accounts versus margin accounts. Cash accounts require that you have the money to buy shares. Margin accounts allow you to borrow to purchase. Given the higher volatility of small-cap companies, sticking with cash accounts is probably the best move for most people.

While the first step is research, don't let the prospect necessarily scare you off, as there are some advantages you get over trying to understand large corporations. "They tend to be simpler companies, maybe only one or two product lines and they're more focused," says Jim Polk, head of equity investments at mutual fund firm Homestead Funds. "They tend to be easier to analyze than a large-cap company."

As with other types of stock, there are two major ways to invest. One is to pick individual stocks. The other, to use index-style funds to get exposure across the small-cap landscape.

"The small caps aren't going to end up being large caps," despite some notable cases to the contrary, says Polk, who does actively trade small-caps at Homestead. He says an investor who wants to trade individual small-caps needs about 55 in a portfolio, most of which will deliver the value they can within a few years. It takes constant monitoring. Most people he says would be better off with a fund that focuses on small-caps or on a small-cap index fund.

A good option is a mutual fund or ETF that tracks the Russell 2000 index. "My advice to small cap stock investors would be to invest in an index fashion because it is so hard to pick winners and losers, and with the added volatility in the small cap universe, hedge your bets," Johnson says. A Russell 2000 index fund or ETF gives broad exposure to a representation of the entire Russell 2000, so you can benefit from the overall performance of the market.

"It's a great space," Polk says. "It should be part of your portfolio for sure. But given some of the characteristics of the small cap space, you don't want to make it too much. That's for each individual to come up with that."

If you do want to try your hand at stock picking at that level, look for companies with experienced management and balance sheets. "We’re looking for companies with good products or services that are well positioned and taking market share," says Polk.

Matt Parker, vice president and portfolio manager at Intrepid Capital, says that there is currently a split in pricing among small-caps. "There definitely seems to be certain stocks that are pricing in a continuance of a nicer economic environment, a soft landing, and some that aren't," says Parker. He's looking for stocks that will withstand tougher economic times, and so is also looking for pricing that recognizes the risk.

"We found a lot of value in technology hardware," Parker says. "These are companies that make things like chips, components, and other materials that enable a lot of the technology. It's been unappreciated that if everything is going to be connected, that takes a ton of hardware infrastructure."

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Here are five small-cap stocks and funds that you might consider.

Collegium is a specialty pharmaceutical company focused on the commercialization of products that help treat severe and chronic pain in cases where other options are inadequate. The company currently has four different products that are alternatives to traditional opioids for treatment of severe pain. Product revenues in the final quarter of 2022 surged nearly fivefold from the prior year to a record $129.6 million. The company achieved FY 2022 net income of $42.2 million, or $1.09 per share. Collegium issued $241.5 million in new convertible notes on top of a $173.7 million cash balance at the end of 2022 but retired $140 million in existing convertible debt that wouldn't have come due until 2026. It also looks in good position to deliver on strong operating and sales forecasts for 2023.

Build-A-Bear is best known as an experiential specialty retailer where guests can make their own plush toys by participating in the stuffing, fluffing, dressing, accessorizing and naming of their own teddy bears and other stuffed animals. Although traditionally dependent on in-store presence, the company has also significantly enhanced its online presence by introducing engaging digital purchasing experiences like its online Bear-Builder, its animated Bear Builder 3D Workshop, an age-gated adult-focused Bear Cave and its brand new HeartBox gift site. Despite unfavorable currency exchange rate movements shaving $2.5 million off the top line, fiscal 2022 Q3 revenues climbed 9.8% to $104.5 million on persistently strong brand interest from consumers. Sales volume through its third-party retail model and franchisees was even stronger, resulting in commercial and international franchising revenues surging 50.1% and 34.2% to $4.1 million and $1.1 million, respectively. Net income grew 25.9% to $7.5 million, while a 9.1% reduction in share count stemming from the company's aggressive buyback activity over the past year boosted the gain in earnings per share to 41.7% to 51 cents, which was much higher than the 38-cent profit analysts had been projecting.

Phibro is a leading global diversified animal health and mineral nutrition company that partners with livestock producers, farmers, veterinarians and consumers who raise and care for farm and companion animals. Its products include a broad range of solutions for food and companion animals—including poultry, swine, beef and dairy cattle, aquaculture and dogs—that help prevent, control and treat diseases and support nutrition to help maintain and enhance animal health and well-being. Aided by a favorable product mix, the adjusted operating margin (excludes acquisition-related costs and foreign currency changes) improved 33 basis points to 9.05%, although a much higher tax rate versus the prior year period meant adjusted net income rose by 13.3% to $14.5 million or 36 cents per share.

Johnson suggests two small-cap ETFs, to gain benefits of the broader market in small-caps without having to keep on top of individual stocks. "The iShares Russell 2000 has nearly $50 billion in assets under management," he says. It has an expense ratio of 0.19% and currently carries a 3-star rating by Morningstar MORN .

This second ETF has $13.5 billion in assets, a 3-star rating by Morningstar, and an expense ratio of 0.07%, which helps your earnings grow faster.

Mispriced stocks are hiding in plain sight and present great investment opportunities. Forbes’ top investment experts share 7 overlooked stocks for the year ahead in this exclusive report, 7 Best Stocks To Buy for 2023. Click here to download it now .