- 1Small caps ($300M–$2B market cap) historically outperform large caps by ~1.5% annually
- 2Small caps benefit most from factor investing due to less analyst coverage and more mispricing
- 3Our model ranks small caps alongside large caps — quality small caps often score highest
- 4Small-cap value stocks (cheap + profitable + low coverage) offer the greatest alpha opportunity
- 5Risk is higher — liquidity, concentration, and information asymmetry all increase
#Why Small Caps Deserve Attention
The Size Premium
Academic research (Fama & French, 1992) documented that smaller companies earn higher returns over long periods. The "size premium" exists because:
- 1Less analyst coverage — fewer eyes means more mispricing
- 2Higher information asymmetry — insiders know more than the market
- 3Greater growth potential — a $500M company can 10x; a $500B company can't
- 4Illiquidity premium — investors demand compensation for harder-to-trade stocks
Where Our Model Shines
Factor investing is most effective where markets are least efficient. With small caps:
- Only 2-3 analysts cover the average small cap (vs. 20+ for mega caps)
- Price discovery is slower — factor signals have more time to generate returns
- The spread between top-scored and bottom-scored small caps is wider than for large caps
This means our 6-factor model adds the most value precisely where most investors aren't looking.
#How to Find Quality Small Caps
Not all small caps are created equal. Many are unprofitable, volatile, and headed lower. Our model separates the gems from the junk using the same six factors:
Profitability (The Key Filter)
The single most important filter for small caps. Many small caps are unprofitable — our profitability factor immediately eliminates companies burning cash. Focus on small caps with profitability scores above 60.
Momentum (Trend Confirmation)
Small-cap momentum is especially persistent. Academic research shows the momentum premium is stronger in small caps because price discovery takes longer.
Value (Avoiding Overpayment)
Small-cap valuations can get extreme — both cheap and expensive. Our value factor keeps you grounded, identifying small caps trading at reasonable multiples.
Low Volatility (Sleep at Night)
Small caps are inherently more volatile. Our stability factor identifies the subset with relatively predictable price behavior — these tend to deliver better risk-adjusted returns.
#Small-Cap Sector Opportunities
| Sector | Small-Cap Characteristics | What to Watch |
|---|---|---|
| Technology | Niche software, cybersecurity, SMB tools | Recurring revenue + positive FCF |
| Healthcare | Specialty pharma, medical devices | Revenue stage (not pre-revenue biotech) |
| Industrials | Specialty manufacturing, niche services | Pricing power + long customer contracts |
| Financials | Regional banks, specialty insurance | Book value discount + improving NIM |
| Consumer | E-commerce brands, restaurants, franchises | Unit economics + same-store growth |
#Small-Cap Value: The Alpha Machine
The intersection of small caps and value investing has produced some of the strongest returns in financial history:
| Strategy | Historical Premium vs. S&P 500 |
|---|---|
| Small-cap (size alone) | +1.5% annually |
| Value (value alone) | +3-5% annually |
| Small-cap value | +5-8% annually |
Source: Fama-French factor data, 1927–2024
Our model implicitly captures this by ranking all stocks on value alongside other factors. Small caps that score high on both value AND profitability represent the intersection of two powerful premiums.
#Risks of Small-Cap Investing
Liquidity Risk
Small caps trade fewer shares daily. This means: - Wider bid-ask spreads (higher transaction costs) - Harder to exit positions quickly - Potential for price impact when buying or selling
Information Risk
Less coverage means less publicly available information. You're more reliant on the company's own disclosures.
Concentration Risk
A single small cap going to zero hurts more than a single large cap dropping 20%. Diversify across at least 15-20 small-cap positions.
Survivorship Bias
Historical small-cap returns may look better than reality because failed companies drop out of databases. Our model mitigates this by continuously monitoring and re-ranking.
#Building a Small-Cap Factor Portfolio
- 1Start on our rankings page — filter for stocks with market cap $300M–$2B
- 2Prioritize composite scores above 70 — quality matters even more in small caps
- 3Check profitability scores — eliminate small caps with profitability below 50
- 4Verify liquidity — ensure average daily volume exceeds $1M
- 5Diversify across sectors — own at least 5 sectors to reduce concentration risk
- 6Position size appropriately — smaller positions for smaller, riskier companies
Last updated: February 23, 2026