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Small-cap stocks too often make the headlines for the wrong reasons, including massive price swings, fraudulent activity, and accounting scandals. Most investors prefer large-cap and mega-cap stocks, such as those in the Magnificent Seven. Yet small-cap stocks offer the best growth potential of any cap size stocks. Should you consider adding some underdogs to your portfolio?

While there is no universal definition, small-cap stocks are publicly listed companies with market capitalizations between $250 million and $2 billion. The “cap” is short for market capitalization, which is the number of shares multiplied by the share price. For example:

• Company XY2 has 50 million shares, and each share trades at $10.
• Therefore, the market cap is $500,000,000 (50 million x $10).

The Russell 2000 equity index is the primary small-cap index. It covers 2,000 small caps with market values between $240 million and $6 billion. Some argue that a few components of the Russell 2000 are mid-cap stocks, as the equity bull market has technically lifted them out of small-cap territory. Other small-cap indices are the S&P SmallCap 600 and the MSCI USA Small-Cap Index.

The Financial Industry Regulatory Authority (FINRA) has the following definition of small-cap, medium-cap, and large-cap stocks:

• Small-cap stocks have a market cap from $250 million to $2 billion.
• Mid-cap stocks have a market cap above $2 billion but below $10 billion.
• Large-cap stocks have a market cap exceeding $10 billion.

Why Should You Consider Buying Small-Cap Stocks?

Small-cap stocks offer exciting stories, disruptive technologies and services, portfolio diversification, and can deliver above-average growth, but investors must accept higher risks. Here are a few things to consider when evaluating small-cap stocks:

• Look for companies with a product or service in a high-growth sector with a disruptive advantage.
• Favor small-caps with annualized EPS growth of 25% or more.
• Ensure the current price trades at a discount to the average analyst price target.
• Buy small-cap stocks in a separate portfolio and do not mix them with other investments.

What are the Downsides of Small-Cap Stocks?

Investing in small-cap stocks carries greater risks due to unknown factors, shaky balance sheets, and challenging business conditions. After all, there is a reason why small-caps are small-caps. Investors must also accept greater volatility.

Here is a shortlist of potential small-cap stocks to consider:

• DigitalBridge Group (DBRG)
• Teradata Corporation (TDC)
• Lithium Americas Corporation (LAC)
• Consolidated Water (CWCO)
• Evolv Technologies Holdings (EVLV)
• SES AI Corporation (SES)
• Innodata (INOD)
• Xunlei (XNET)
• Serve Robotics (SERV)
• X Financial (XYF)

Update on My Previous Best Small-Cap Stocks to Buy Now

In the previous installment, I highlighted the upside potential of DigitalBridge Group and Teradata Corporation.

• DigitalBridge Group: A long position taken in the stock between $9.06 and $9.84. DigitalBridge Group rallied over 33%, and I closed my position at $13.50. While price action corrected into its ascending 38.2% Fibonacci Retracement Level, I am not re-entering this trade.
• Teradata Corporation: A long position taken in the stock between $20.15 and $20.97. Teradata Corporation advanced over 13%, and my stop-loss closed it for a profit at $22.50, just shy of 10%. The correction has brought the price back into my previous buy zone, and I will go for round two.

Evolv Technologies Holdings Fundamental Analysis

Evolv Technologies Holdings provides AI-based, non-invasive, advanced security technologies and security screening solutions. It transforms physical security with advanced, extensible solutions designed for schools, stadiums, transit hubs, and corporate offices.

So, why am I bullish on Evolv after its price doubled since April?

The need for non-invasive AI-based security solutions remains in its infancy, but I expect demand to outstrip supply moving forward. The addressable market for Evolv Technologies Holdings is expanding, which should boost double-digit revenue growth. Evolv Technologies Holdings reported positive cash flow from operations, gross margins rank among the best in its industry, and the earnings-per-share growth is impressive.
 

Evolv Technologies Holdings Fundamental Analysis Snapshot

The price-to-earnings (P/E) ratio for the stock is negative. By comparison, the P/E ratio for the S&P 500 Index is 29.79. The average analyst price target for Evolv Technologies Holdings is $9.50. This suggests excellent upside potential with manageable downside risks.

Evolv Technologies Holdings Technical Analysis
 

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Evolv Technologies Holdings Price Chart

The Evolv Technologies D1 chart shows price action between its ascending 38.2% and 50.0% Fibonacci Retracement Fan levels. It also shows the stock inside a bullish price channel.

Meanwhile, the Bull Bear Power Indicator turned bearish, but near its ascending trendline.

My Call on Evolv Technologies Holdings

I am taking a long position in Evolv Technologies Holdings between $7.82 and $8.20. I expect to see the company secure more long-term contracts with hospitals and public school systems, while its ongoing advancements and updates should continue to boost client retention rates.

X Financial Fundamental Analysis

X Financial is a Chinese FinTech platform connecting borrowers on its platform with its institutional funding partners. Thanks to its big-data-driven technology, the company has established numerous strategic partnerships with financial institutions.

So, why am I bullish on X Financial despite its pullback?

I like how X Financial uses its technology to facilitate loans to prime borrowers while it deploys robust risk assessment and control systems. The top three shareholders hold 54% of X Financial, while its CEO holds a 43% stake, with limited institutional shareholdings. Therefore, buying this FinTech firm means buying the vision of its CEO, who has done a remarkable job to date, as confirmed by operational stats that rank at the top of its industry.
 

X Financial Fundamental Analysis Snapshot

The price-to-earnings (P/E) ratio of 2.67 makes X Financial an inexpensive stock. By comparison, the P/E ratio for the S&P 500 Index is 29.79. The average analyst price target for X Financial is $15.00. This suggests moderate upside potential with decreasing downside risks.

X Financial Technical Analysis
 

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X Financial Price Chart

The X Financial D1 chart shows price action above its descending Fibonacci Retracement Fan. It also shows the stock entering a massive horizontal support zone.

Meanwhile, the Bull Bear Power Indicator is bearish, but it remains within its ascending support level.

My Call on X Financial

I am taking a long position in X Financial between $11.62 and $13.20. The stock has excellent operational statistics, a deep understanding of its market, creates shareholder value, and pays a good dividend yield, which is rare for a small-cap stock. X Financial is one of the most undervalued stocks I have researched this year.

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