Why Small Cap Stocks?

In investing, you'll run across companies that are considered "blue chip", "large cap", "small cap" etc etc. In basic terms, this has to do with the financial size of the company.

Cap is short for capitalization which is a measurement of economic size and is equal to the number of shares outstanding times the share price. For example: at closing time on July 19, Verizon (VZ) had a share price of $29.66 and 2.84 billion shares outstanding giving it a market cap of $84.25 billion. This is a large cap company.

So why do I try to look at small(er) capitalization companies?

Potential.

Much like the 10 year old with a 38 inch vertical has a lot of potential in high school basketball, a good small cap company has a lot of potential going forward as well.

Plus, basically every large cap company today once started out as a small cap. Let's look at Ford Motor Company (F).

While the American auto-makers, including Ford, have certainly seen their market cap fall in the past year, Ford's market cap as of market closing on July 19 was $18.15 billion. Compare that to 1982 when Ford was merely a $815 million company. As you can tell, that's quite a difference - a nearly 700 percent difference!

That's not to mention Ford's peak in 1999 at $73.02 billion. Every $100 invested from January 1 1982 when Ford was a small company would have returned you over $5000 if you sold in early May, 1999. That's the kind of potential a small cap has!

So do you think you'll ever see 5000 percent gains from buying Microsoft (MSFT) and Apple (AAPL) stock these days? Dream on. While both companies have earned great returns for their investors over the years, you won't see enormous wealth growth from owning Microsoft stock.

To really pursue growth, you have to uncover the small stocks with great potential.

Let's start with a basic definition. Small cap is roughly between $250 million to $1 billion. The edges on that definition can be blurred a bit, but that will give you range to start with.

Let's look at Research in Motion (RIMM), the maker of the BlackBerry devices. In early 1999, Research in Motion was a small cap company with a market capitalization of $490 million. Today RIMM has a market cap of $44.22 billion, representing a return of over 3800 percent. Yes - for every $100 invested in early 1999, you'd now be sitting on $3800+.

Of course investing in small cap companies will open you up to more risk than investing in the sturdy stalwarts like Microsoft, Johnson & Johnson (JNJ) and General Electric (GE). But you won't see the potential for big returns with said companies.

Not to mention, guess where Microsoft started out in 1986? Yep - a small cap! It's simply risk versus reward.

Investing in small caps works best if you have a longer investment horizon - hence why I suggest getting started young. Being younger, I have (hopefully) many more years of earning and investing in front of me and I can rebound if an investment takes a dive.

But to truly ride an investment out of the park, you'll have to dig around a bit. Simply throwing money at a company because their current market cap is $300 million won't do you a lick of good.

Find a small cap company with good fundamentals like a dedicated and invested management/ownership team, a strong balance sheet and good forward earning potential. Only then can you hope to turn $100 into $23,000+ like the early investors in Microsoft have.

These days I'm investing in a number of small and large caps. It's always wise to keep some money in a safer, more stable company like Microsoft, Johnson & Johnson and General Electric (I don't own shares in any, but not because I wouldn't like to). But you should keep some money ready to pounce when you find a small cap company that you like and which has potential.

So why small caps? Because I don't want to work all my life, and with that kind of potential, I may not have to!

*Note* All historical market cap information came from using the WolframAlpha engine. I had a heck of a time trying to dig it up otherwise.