What are Small-Cap Value Funds?

Allegra J. Lingo
Allegra J. Lingo
Woman holding a book
Woman holding a book

Small-cap value funds are mutual funds comprised of undervalued small-cap stocks. These stocks are generally shares of businesses with a market capitalization of $300 million US Dollars (USD) to $2 billion USD, although this definition varies between brokerage houses and over time. Due to the stocks' perceived undervalue, investing in funds can potentially provide high-risk tolerant investors with aggressive growth opportunities through substantial dividend payments and rapid rises in stock value.

Market capitalization is calculated by multiplying the price of the stock by the number of outstanding shares. Due to their size, most small-cap stocks are found on small stock indexes, such as NASDAQ in the United States, FTSE 250 in the United Kingdom, and Russell Global Small Cap. Most institutional investment companies pay attention primarily to larges indexes, such as the Dow Jones Industrial and S&P 500 in the United States, the FTSE 100 in the United Kingdom, and the Russell Global Index. This means many small-cap stocks often go unnoticed by large investment houses, which potentially translates to these stocks trading at a significantly lower value than the companies' fundamentals would justify. Investors in small-cap value funds purchase stock at a low rate and benefit from large value growth when market analysts do turn their attention towards these stocks.

Adaptability to consumer and market changes is another advantage to small-cap investing. The workforce and bureaucracy of these companies is smaller and usually less-complicated. Capitalizing quickly upon trends is feasible for this size company, whereas changes within large-cap companies are often more complicated and take more time. This may translate to a higher growth rate. For example, in the United States between 1997 and 2007, small-cap stocks increased in value at a rate of 12 percent per annum, while large-camp stocks increased at a 10 percent rate per annum.

The buy-out potential of small-cap companies is also a positive for investors. A buy-out of a successful company increases its stock value. The rumor of a buy-out makes the stock attractive to other investors, also driving up the stock price.

The downside of small-cap investing is due to its high-risk and volatile nature. As much as there is the potential for aggressive growth, there is also the potential for rapid decline in stock value. For example, stock in many technology companies are considered small-cap. During the mid and early 1990s, these funds grew at high rates, but lost significant value in the subsequent dot-com bust.

Small-cap value funds are viable investments for high-risk investors who seek aggressive growth but also have the time and patience to ride out market downturns. Although the media and market analysts do not always pay attention to these funds, all small-cap funds must register with the SEC, increasing transparency to individual investors. Potential investors should talk to an investment advisor for specific information on the small-cap value funds they offer.

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