One of the most important terms in investing is "market cap." Every company is some kind of "cap." There are large caps, small caps, midcaps and even microcaps. I'll get into the differences among them in a minute.

But first let's understand where "cap" comes from.

When analyzing a company, the most important thing to look at is how much it is worth, or at least how much the market thinks it is worth. That's called the company's market capitalization, or "cap." Here's how it is figured out…

Say Company X has 100 million shares outstanding and a price of $12 per share. That would give it a market cap of $1.2 billion. The market cap is just the number of shares outstanding multiplied by the cost per share.

But the classification of company sizes is the key idea. For instance, a large cap (market cap of over $10 billion) cannot grow as much and as fast as a small cap ($100 million-1.5 billion). Certainly, a microcap (under $100 million) can grow even faster, and a midcap ($1.5-10 billion) falls somewhere in between.

[Side note: For our purposes, we'll combine small and microcaps… So everything under $1.5 billion will be a small cap.]

History sides with small caps. Rolf Banz made a famous study back in the early 1980s, called "The Relationship Between Return and Market Value of Common Stocks." In this important report, Banz found that over the 50-plus years he studied, the smaller the company, the larger the average return. This held true for all the years he studied, regardless of whether the market ended the year up or down.

Here are the exact results:

Table: "What Has Worked in Investing," Tweedy, Browne Co.

As you can see, if you had invested in the smallest companies over that period, you would have made nearly five times what you would have had you invested in the blue chips.

That's the simplified reason why we love small caps. So why isn't this called the Small-Cap Sleuth? Well, we like to break it down even further. Let me explain…

Penny Stocks vs. Small Caps

Let's return to our previous example.

Company X has a market cap of $1.2 billion (100 million shares times $12 per share). That's a small-cap company, but not a penny stock. Penny stocks are defined as anything with a market cap under $1.5 billion (hence, they are all still small caps) and a price per share under $10. So you can see Company X doesn't fit both requirements. Therefore, we wouldn't recommend it.

Now, let's say Company X has a 2-for-1 split (meaning if you owned one share before the split, you'd own two after). Now there are 200 million shares, but the share price is only $6. That would make it a penny stock. It now falls perfectly within our range.

So why would we recommend only penny stocks? Well, there are a number of factors…

First, there is market psychology at work here…

When certain investors see a $6 stock, they think it's cheap. This may not be the case. If it had the same market capitalization at $50 per share, the investor wouldn't think that way. So penny stocks look considerably cheap compared with other small caps.

That's one reason. Another is buying power.

With penny stocks, it is far easier to buy more shares as well as diversify between companies. Say you have 4 companies you're interested in buying, but only have $100 to spend. If they are all $50 a pop, you can't do it. Now, if they are all $5 per share, you can get into all of these positions. Thus, buying a diversified portfolio.

The third reason for picking penny stocks over more expensive ones is the price itself.

If a company is sitting at $50 per share, it takes $5 swings to really start seeing profits or losses. With a $5 company, it takes only about 50 cents, which can easily be done in a day of trading. The smaller the price per share, the larger the price swings. That's how short-term penny stock traders have been making millions over the years.

Whether you are a short-term investor or in it for the long haul, you can see that small caps, and specifically penny stocks, are the way to go.

The truth is we love small caps. It's far easier for a $100 million company to double than it is for a $100 billion one. It's as simple as that…

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Sincerely, Jim Nelson

P.S. Over the years, many have tried to refute Banz's study. Critics say that it doesn't factor in companies that go belly up and fall off major exchanges. There is some merit to this. So instead of blindly picking small caps to invest in, it's good to have someone in your corner. The Penny Sleuth is in your corner.