Setting Things Straight About Small Caps and Penny Stocks

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There’s a giant misconception of what a small cap or penny stock actually is. At their root, they are neither bad companies nor get-rich-quick schemes. They, of course, can be either of those things individually. But not as a group.

Today, I want to break out exactly what it means to be a small cap or penny stock investor… and why it’s important to your financial health.

First, some definitions:

Small Cap

plural: small caps

A publicly-traded company with a market capitalization (shares outstanding multiplied by per share price) of less than $2 billion

Penny Stock

plural: penny stocks

A publicly-traded company, whose per share price is below $1

These are the most simply of terms. Yet investors frequently misuse them. Surely, you’ve seen articles about companies trading at $5 or even $10 call them penny stocks. Likewise, you probably have heard these terms used interchangeably. As you can see from their strict definitions, that’s not the case.

The problem comes from how brokers classify them. Some include companies with market caps of $5 billion to be small caps… somehow. The Russell 2000 Index, for instance, has one holding with that size market cap. Yet, investors frequently cite the Russell 2000 as the small cap index.

Penny stocks come with even more confusion. Even Investopedia – a generally decent source for pure financial definitions and information – claims a company with a $5 price tag can be a penny stock. Think about that. That’s 500 pennies. At some point, you’d have to start calling it a “dollar” stock or something else.

These alternative and loose definitions have major impacts, unfortunately. When you hear the term penny stock, it often is used in a derogatory manner. Financial media likes to label companies out of favor with the market with the tag “future penny stock.”

Just consider this. On January 9th of this year, Seeking Alpha – which admittedly publishes a wide variety of voices – ran a headline “General Electric Will Be A Penny Stock In 2019.” Three days later, on the 12th, it put out a second piece titled “General Electric Is Not Going To Be A Penny Stock.”

The debate was whether the slumping GE stock would fall below $5 – as both articles noted was their cutoff for the term. But the derision of the term sticks out. Both articles argued that GE trading as a penny stock would be a world-changing event. It wouldn’t be, by the way. Plus, the company bounced back above $10 earlier this month.

But, even if GE would fall below $5… or even $1 per share… it wouldn’t even be close to a small cap. Meaning, GE would certainly be smaller than it is today. But a fall like that still doesn’t put a company this big into small cap territory. To put it in perspective, if GE fell to $1 per share, it’s market cap would be about $9 billion… no where near small cap land.

This whole puzzle over investor language is important, even if a bit absurd. Because the minute a stock is labeled a penny stock or a small cap – it excludes a certain group of investors.

You see, many institutional investors – private capital, mutual, hedge and even sovereign funds, etc. – aren’t allowed to touch anything labeled as either a penny stock or small cap. They have rules set up to stay away from those types of companies because they are more volatile.

In turn, without interest from institutional money, Wall Street has less interest in covering these kinds of stocks. Meaning, there’s less analyst numbers and overall scrutiny. That increases these companies’ volatility even more.

It’s a vicious cycle, we’ve written about before. But that doesn’t mean you personally should avoid these kinds of companies. In fact, there’s plenty of proof that they offer tremendous opportunity.

One of the most in-depth studies I’ve ever read on asset performance throughout history shows just how important small caps are to overall market gains.

Here are the results:

Just look at those numbers. Those are the total returns of each group of stock dating back to the Great Recession. Small caps, especially small cap value stocks (the ones we focus on), beat their larger brethren nearly every decade over this 80-year period.

So, when you read the next story using “penny stock” or “small cap” in a derogatory way, in a way to make the company in question sound terrible, give it another thought. There might just be something there… something that has the potential to beat the rest of the market

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