What are small-cap stocks?

A small-cap share can be categorised as a company with low market capitalisation and the potential for strong earnings growth. They tend to be early-stage companies that have scope to improve annual profits faster than more established businesses.

If you’re looking for small-cap stocks in the UK, you’ll need to look further afield than the FTSE 100 and the FTSE 250.

On the London Stock Exchange, the term ‘small cap’ refers to companies with a market capitalisation between £50m and £230m. This is vastly different from the United States, where stocks in this category have much larger market caps, ranging between $300m and $2bn.

Small-cap stocks can be found across a variety of UK stock indexes. There is a dedicated FTSE SmallCap Index, which contains scores of these smaller businesses and forms part of the FTSE All-Share Index.

However, while the FTSE All-Share contains around 600 stocks, small caps make up only a tiny number of the total. The index is predominantly made up of FTSE 100 and FTSE 250 shares that fall outside that £50m to £230m market-cap range.

Top UK small-cap stocks to buy

Here are three small-cap stocks for UK investors to consider today.

Atlantic Lithium

Atlantic Lithium traded under the name of IronRidge Resources up until November 2021. The business is involved in the discovery of lithium in West Africa, an important element used in the manufacture of batteries. Demand for the element is tipped to soar as sales of electric vehicles take off.

Atlantic Lithium has described the West Africa region as a “new lithium frontier”. Its flagship asset is the Ewoyaa project, a high-grade source in Ghana. Testing work here has been consistently positive and recent drilling revealed the potential to expand the resource.

The asset currently has a mineral resource of some 30.1m tonnes and an estimated mine life of just over 11 years. And it is located close to critical power and transport infrastructure, including a major highway. It is within 70 miles of the port city of Takoradi.

Through an agreement with Piedmont Lithium, Ewoyaa is funded all the way through to production. In exchange for the funds to fast-track the asset, Piedmont — which owns a near-10% stake in Atlantic Lithium — could earn up to 50% of the small cap’s lithium portfolio in Ghana.

Zoo Digital

Zoo Digital provides cloud-based software that allows television and film producers to globalise their product. Its major customers include Netflix, Disney, Apple, Amazon, and Warner Bros Discovery.

Content producers are spending huge amounts to showcase their product to a growing global audience. This has stepped up during this age of streaming, and trading at Zoo Digital is accelerating sharply. Organic revenues here soared 78% year on year during the financial year to March 2022.

Zoo Digital adds dubbing, voiceovers, and subtitles to TV shows and movies that allow foreign viewers to understand the action. Other localisation services include ensuring that product-related artwork is appropriate for different markets.

The business offers other critical services to content makers too, such as adding audio description for visually impaired English and foreign audiences. It also handles metadata to provide viewers with added content (like actor biographies and character information). And it provides mastering services, help with scripting, and assistance with compliance.

iomart Group

In an increasingly digitalised world, demand for iomart Group’s services could be set to soar. In fact, this small-cap company’s outlook has improved in the post-pandemic environment as working practices evolve. It now expects to double revenues between now and 2026 (to £200m).

iomart provides cloud infrastructure that allows IT users to store their data in multiple places. Platforms like the hybrid cloud are becoming rapidly more popular as more and more workers split their time between home and office.

iomart helps businesses eliminate communication problems that can emerge from workers hopping locations, too. It helps workers collaborate in a shared space with the use of the Microsoft Modern Workplace suite of products. And it manages wide area network (WAN) circuits that keep business locations connected and supplies cloud-based telephone services.

Finally, this small cap is an expert in helping to reduce the rising threat of cyber attacks. iomart provides data management services that allow clients to back up their information and carry out disaster recovery. It also identifies threats to businesses before they can wreak havoc.

Risks of small-cap stocks

There are a few risks related to small-cap shares to be mindful of.

• Small caps usually have less balance sheet strength than larger companies. Many also don’t generate any profits. This means they have less financial clout to use to pursue growth opportunities. They often also lack the economies of scale that large-cap stocks can benefit from.
• UK small caps are generally considered unsuitable for a risk-averse investor. When a smaller business experiences stress due to company, industry, or economic factors, it tends to be more vulnerable to failure.
• Small cap stocks can be prone to extreme share price volatility. They can soar when good news comes in but sink when times get tough. Therefore, investing in small caps may not be suited to individuals who either can’t or don’t want to own a stock for several years at least.

Are small-cap stocks right for you?

The rewards of investing in small market cap stocks can be huge if a company can identify a market opportunity and exploit it effectively.

Take ASOS, for example. The online retailer traded inside small-cap territory for a period during the mid-2000s before surging in value as e-commerce took off. The business now has a market cap of £927m and trades on the FTSE 250.

Many other small caps have exposure to industries and trends that could lift their value through the roof in the coming decades. Some of the predicted hot growth industries of tomorrow are:

• Automation and robotics
• Green technologies (including electric vehicles and renewable energy)
• Healthcare
• Management consultancy

Smaller companies can be an excellent choice for investors who are happy to hold them for the long haul. But the high rate of failure of these companies — and the extreme choppiness of their share prices — mean that investors need to tread carefully before splashing the cash.