There has been a decent amount of attention given to small cap stocks recently. A client asked what exactly makes a stock “small cap” and why some believe they are well positioned in today’s environment.

Market Capitalization

Before looking at small cap stocks, let’s look at the word “cap” – which is short for capitalization. All public companies have a market capitalization – which is the product of their shares outstanding * share price. Said another way, market capitalization is the current fair value of a company’s outstanding shares.

Small Capitalization (Cap) Stocks

Small-cap stocks are shares of publicly traded companies with a relatively small market capitalization (compared to the entire public market), generally between $250 million and $2 billion. (Mid cap companies are usually $2-10 billion and large cap are over $10 billion).

A company may be small cap for a variety of reasons – it may be in a newer industry, it could be in a developing sector, it could be a nascent business, etc. However, many very well established businesses, with strong financials and solid growth may also be small cap. Again, it is simply a representation of the shares the company has issued multiplied by its share price.

How do small cap companies compare to their larger cap peers (market caps over $10 billion)? There are certain broad-brush comparisons investors may hold as known truths such as large-cap companies being more stable and small cap companies being riskier. But as always, a complete comparison would rely on a close look at the businesses themselves and the underlying fundamentals. However, one statement that tends to hold true (on a broad-based/index level) is that the small-cap universe tends to be more rate sensitive – meaning small cap indexes (such as the Russell 2000) tend to move in response to movements in interest rates more than their larger-cap peers.

Small Caps and Interest Rates

Why do small cap stock indexes tend to be more rate sensitive? As a group, smaller market cap companies tend to rely more heavily on debt financing. They have issued less stock than larger-cap peers and need some ways to access capital to fund their operations and growth. Given their higher debt loads, changes in interest rate impact their profitability. As rates rise, the companies need to pay more in interest/debt coverage on variable debt or may need to refinance debt at increasing interest rate levels. However, as rates fall, the opposite dynamic takes hold. Companies may be able to refinance debt and pay less in interest over time.

While larger cap companies may also borrow to finance operations, they tend to have a lower percentage of debt and interest expense tends to be less meaningful to its results.

Given this dynamic between smaller cap companies and rates, small cap companies are once again getting a lot of attention. As it is becoming all but certain amongst many that the Federal Reserve will lower rates at the September meeting, small cap indexes are rallying.

Right for you?

There is no one right answer to this question. As always, it depends upon your risk profile, investment allocation, and portfolio composition. An allocation to small cap stocks (either via an index or individual companies) may make sense (especially in favorable rate environments) but be sure to evaluate the, in context of your overall financial picture