Introduction to Small Cap Investments and Speculative Stocks - dummies

Introduction to Small Cap Investments and Speculative Stocks

By Paul Mladjenovic

Every stock investor wants to get in early on a hot new stock. Why not? You buy Shlobotky, Inc., at $1 per share and hope it zooms to $98 before lunchtime. Who doesn’t want to buy a cheapy-deepy stock today that could become the next Apple or Walmart? This possibility is why investors are attracted to small cap stocks.

Small cap (or small capitalization) is a reference to the company’s market size. Small cap stocks are stocks that have a market value under $1 billion. Investors may face more risk with small caps, but they also have the chance for greater gains.

Out of all the types of stocks, small cap stocks continue to exhibit the greatest amount of growth. In the same way that a tree planted last year has more opportunity for growth than a mature 100-year-old redwood, small caps have greater growth potential than established large cap stocks.

Of course, a small cap doesn’t exhibit spectacular growth just because it’s small. It grows when it does the right things, such as increasing sales and earnings by producing goods and services that customers want.

For every small company that becomes a Fortune 500 firm, hundreds of companies don’t grow at all or go out of business. When you try to guess the next great stock before any evidence of growth, you’re not investing — you’re speculating. There’s nothing wrong with speculating, but it’s important to know that you’re speculating when you’re doing it.

Consider these two points when investing in small cap stocks:

  • Make sure that a company is established. Being in business for at least three years is a good minimum.

  • Make sure that a company is profitable. It should show net profits of 10 percent or more over two years or longer.

These points are especially important for investors in small stocks. Plenty of start-up ventures lose money but hope to make a fortune down the road.

A good example is a company in the biotechnology industry. Biotech is an exciting area, but it’s esoteric, and at this early stage, companies are finding it difficult to use the technology in profitable ways. You may say, “But shouldn’t I jump in now in anticipation of future profits?” You may get lucky, but understand that when you invest in unproven, small cap stocks, you’re speculating.