It's important investors understand that, in general, investing in smaller companies comes with higher risk but also higher potential reward.
As a general rule, investors should demand a larger margin of safety and should expect small-cap stocks to sell at a discount to the wider market. That's because the risk of a small business experiencing major problems is often much higher.
For example, smaller companies are more likely to be borderline profitable – some are even pre-revenue. Small caps are also more likely to be reliant on a few large customers for the majority of their revenues which creates its own set of company specific risk.
Portfolio structure matters
For the above reasons (amongst many others) investors need to be careful how they structure their portfolio if they wish to own small cap stocks.
In most instances, investors will limit their overall small-cap portfolio exposure to just a few percentage points. Alternatively, investors who are keen to allocate a significant proportion of their portfolio to small cap stocks will diversify widely.
With those general warnings of investing in this sector aside, here is one small-cap growth stock which I think is particularly interesting right now.
Covata Ltd (ASX: CVT)
Covata has developed a secure file-sharing software solution for enterprises known as Safe Share.
Currently one of its most exciting opportunities lies within its "whole of government" direct sales negotiations with several government departments and agencies in the UK.
Importantly, Covata is the only file sharing product available to the UK Government on G Cloud 8 (a cloud technology platform used exclusively by the UK government) that has a Tier 2 Classification up to Top Secret.
While it is still early days in Covata's business development, the fact the company has successfully received accreditation in the UK and can boast of numerous other contracts and backing from a range of leading global and domestic organisations including Cisco, TPG Telecom Ltd (ASX: TPM) and Macquarie Telecom Group Ltd. (ASX: MAQ) makes the outlook for Covata's software products exciting.
Foolish takeaway
Covata's share price is down 37.5% over the past year, trading at a one-year low of 19 cents and with a market capitalisation of $99 million.
The group's Share Safe software has the potential to do for the software security niche what Dropbox has done for the general public.
While the risks are real for investors given Covata's minimal revenues, if one takes an optimistic view of the value the company could derive from just its current opportunity set, there could be significant upside for the business and its share price from here.
