How to spot a small cap stock

Five hands holding up columns on a bar chart - four bars are green, the tallest is pink, signifying picking a successful small cap stock investment

(Image credit: We Are via Getty Images)

published 29 September 2025

Small cap stocks can be a promising source of growth in your portfolio. But they are hard to pick, and unpredictable.

That said, small caps are having a moment. Taylor Wimpey (LON:TW.) was the second-most-bought stock for DIY investors on Interactive Investor in August, despite being a FTSE 250 constituent with a market cap of less than £3.5 billion.

The Russell 2000, an index of US-based small cap stocks, hit a new all-time high of 2,488 on 23 September. Over the preceding three months, the index’s gains of 15.6% outpace those of its large-cap cousin, the S&P 500, which gained 10.5% over the same period.

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The small-cap index’s surge has been underpinned by a rare run of upward earnings revisions, said Lale Akoner, global market analyst at eToro. “Falling financing costs are a key fundamental driver for the performance, with interest expenses now at their lowest in over a year. With markets pricing in further Fed cuts, smaller companies that rely heavily on short-term debt stand to benefit most,” said Akoner.

What to look for in a small cap stock

The challenge when investing in small cap stocks is that, as an asset class, they’re not brilliant.

“Our contention has always been that smaller companies as a whole are pretty low quality,” says Bill Chater, global small cap investment specialist at Baillie Gifford.

This might sound controversial from someone with his job title, especially considering he is part of the team at Edinburgh Worldwide (LON:EWI), an investment trust which focuses on global small cap and private companies. But Chater’s point is that the art of investing in small caps is the ability to spot those small companies with the greatest potential: the ones that could become the large caps of tomorrow.

“We want to look for individually outstanding companies – companies that are immature compared to their ultimate market opportunity,” he says.

There are four factors that Chater and his team look for when selecting small cap investments with this potential:

Innovation, to solve a large problem (which could be addressing a significant market opportunity or developing a new market around their solution)
Establishing a competitive advantage that deepens over time
The quality of the management team, with an emphasis on founder-leaders rather than professional CEOs
Scalability – the potential of the solution they are developing to expand to new heights.

Chater adds that, even though he is a growth investor, valuation is a key factor that he never loses sight of.

“You want to buy a business when it’s relatively cheaply valued, hold it for a period of time, and then sell it when it’s worth more,” he says. As a rule of thumb, Chater and the EWI team are looking for companies that they can realistically see doubling their value as a base case.

How to invest in global small caps

Even the experts find it hard to pick small caps that will reliably turn into mid- or large-cap stocks in the future.

“It’s not necessarily about being right with every investment,” says Chater. “It’s about finding a few special businesses and then being very right with them.”

So if you are managing your own investments, without access to the depth of research that Chater and similar teams have available, it could be wise to outsource the stock picking to small cap experts by investing in an investment trust or a fund.

The average investment trust in the AIC’s global smaller companies universe currently trades on a 12.1% discount (as of 26 September 2025). EWI currently trades at a discount of approximately 7.0%. Other small cap investment trusts trading at narrower discounts than the sector average include Herald Investment Trust (LON:HRI) and Smithson Investment Trust (LON:SSON).

You could also opt for a passive approach to investing in small cap stocks. The Invesco Russell 2000 UCITS ETF (LON:RTYS) tracks the Russell 2000 index of smaller-capped US stocks. Alternatively, for access to global small caps, you could use the HSBC MSCI World Small Cap Screened ETF (LON:HWSS) which tracks the the MSCI World Small Cap Selection Screens Index (whilst integrating ESG metrics).

Remember, though, that passive approaches like these amount to “owning the asset class”, which Chater prefers to avoid in favour of a smaller number of high-conviction small cap stock picks.

Dan is a financial journalist who, prior to joining MoneyWeek, spent five years writing for OPTO, an investment magazine focused on growth and technology stocks, ETFs and thematic investing.

Before becoming a writer, Dan spent six years working in talent acquisition in the tech sector, including for credit scoring start-up ClearScore where he first developed an interest in personal finance.

Dan studied Social Anthropology and Management at Sidney Sussex College and the Judge Business School, Cambridge University. Outside finance, he also enjoys travel writing, and has edited two published travel books.