Small cap stocks are classified as stocks listed on the ASX with a market capitalization between $300 million to $2 billion. These can be highly risky but they can also offer very high rewards. In this article we discuss the pros and cons of trading in small cap stocks.
Advantages
- Small cap stocks have the potential to reap very high share price appreciation as these companies are in the growth phases of development. The capital gains which can potentially be made in small cap stock are much higher than mid cap or large cap stocks.
- Due to the limited liquidity, individual investors can be trade in and out of the stock easier than large institutions. Managed funds investing in small cap stocks usually close the fund to new investors when they have reached a predetermined limit as it would be too difficult for the firm to trade in and out of small cap stock positions
- These companies are frequently subjected to mergers and acquisitions which is a bonus for these investors as takeover offers can increase share prices
- These shares have lower share prices than mid or large cap shares so investors can buy these at cheaper prices
Disadvantages
- As there is a lack of liquidity in small cap stocks, it does not take a lot to move the share price up or down
- These stocks are highly risky and appropriate for investors who have high risk appetite
- As these firms are small, the risk of bankruptcy is higher than a bigger company. This means that these firms risk going bankrupt or delisting from the stock market
- Small cap companies may not be making any profits and be operating on large debt. Investors are buying into these type of stocks as they believe the company will do very well in the future
- These stocks generally do not offer dividends to investors
- There is less coverage of research publicly available for on small cap stocks, investors may need to complete their own fundamental research
Lauren Hua is a private client adviser at Fairmont Equities.
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