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Small Cap Stocks – Features & Advantages

  • Rudri Rawell
  • Nov 04 2021
  • 6 minutes
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As per the Securities and Exchange Board of India (SEBI), small-cap stocks are stocks of companies that rank beyond 251 in terms of market capitalization. Market capitalisation of most small cap companies is under Rs. 5,000 crores. Small-cap stocks are preferred by many investors due to the potential of delivering superior returns. However, these stocks are incredibly volatile and risky when compared to large cap and mid-cap stocks.

What are the special characteristics of Small-Cap stocks?

The two main small-cap indices in India are :

  1. Nifty Small Cap 50 Index
  2. S&P BSE Smallcap Index

Through these indices, investors can gauge the ongoing trends of small-cap stocks in the market. While the Nifty Small Cap 50 index comprises the top 50 small-cap stocks that are most traded in the market, the S&P BSE small cap index comprises the top 250 small-cap stocks in the market. Here are some of the special characteristics of small-cap stocks that investors must consider while investing in these:

Constant volatility

Small-cap stocks belong to less stable companies since most of these are in the growth phase. This causes frequent volatility. These stocks tend to underperform large and mid-cap stocks during market downturns. Small-cap stocks may, however, outperform large and mid-cap categories during a bull market.

High risk

Small-cap stocks are of companies that have not yet established a market presence. These companies often have limited cash reserves. Thus, there are higher chances of these companies having negative cash flows in case of economic slowdowns. Because of this, small cap companies pose a higher risk of going bankrupt in case of economic slowdowns.

Substantial potential for growth

In stock markets, risk and returns tend to go hand in hand. Since small-cap stocks are high on risks, they also tend to have significant potential for growth. The growth opportunities offered by small-cap stocks are not often available in large-cap stocks.

Low liquidity

Small-cap stocks offer lower liquidity when compared to large or midcap stocks. This is mainly because these stocks find very few investors who would like to trade in them. However, a small cap stock can offer better liquidity over time as the company enters the price discovery phase and gains broader stock ownership.

Why should you buy small-cap stocks?

Here are some of the main reasons why investors must consider buying small-cap stocks:

Future growth

Most large-cap companies of today would have at some point been small businesses. Individual investors who participate in such growth stories often manage to gain substantial wealth in a longer-term. 

Lack of mutual fund representation

Mutual funds, in general, tend to buy a large number of shares of companies that they invest in. This depends on the fund’s objective. Most small-cap companies may not form part of mutual funds since they have a limited number of stocks available. Therefore, these are ideal for individual investors who can identify a growth opportunity and invest before the general market gets interested in them.

Long-term value correction

Small-cap stocks do not attract much attention from analysts and markets pay very little attention to these in general. This results in the stocks being undervalued as compared to large- and mid-cap stocks. Thus, the small cap share prices could be far lower than their true value. In the long term, the market valuation may be correct to reflect its true value and an early investor can book large profits in such cases.

Additional read – How to analyse a stock to invest better?

How can investors buy small-cap stocks?

For investors who are just beginning to explore the stock markets, an ideal way to start exploring small-cap stocks is by investing in small-cap mutual funds. Small-cap mutual funds have to invest at least 80% of their corpus in small-cap stocks. Investors who have not invested in small-cap stocks yet can go for a systematic investment plan (SIP) or a systematic transfer plan (STP) to invest in this segment. Small-cap index funds and exchange-traded funds are also good options for new investors.

A seasoned investor can consider investing directly into small-cap stocks after analyzing the selected company’s fundamentals. Since these are listed companies, investors can access most or all of the financial statements online. Before investing in small cap companies, it is important for investors to ensure that the company has a good leadership team in place. A thumb rule for small-cap stock investments is that an investor should restrict the investment to 10-20% of total equity portfolio due to the high-risk levels.

Conclusion

Just like every investment requires investors to know their risk levels, return expectations and investment time horizon, small-cap stocks too can prove beneficial if invested after considering these factors. Since small-cap stocks are high risk, new investors should acquaint themselves with stock market functioning and invest in these once they have acquired basic know-how and gathered risk taking ability.

FAQs

Is it better to invest in a small cap or large-cap?

Small-cap stocks come with higher risks, whereas large-cap stocks carry lower risk elements. Small-cap stocks are good to buy for seasoned investors who can identify companies that have significant growth potential. Large-cap stocks, on the other hand, are ideal for risk-averse investors who want regular income through dividends.

How to invest in small-cap stocks?

To invest in small-cap stocks, an investor must have the basic know-how on how to track stock price movements. This will help in identifying high potential companies that are currently small cap and may become mid or large cap in the long run. Investors can also seek a financial expert’s help to invest in small-cap stocks.

What are the alternatives to small-cap stocks?

Investors can consider building a portfolio of large-cap, mid-cap stocks apart from small-cap stocks. Investing in hybrid funds can also provide balance in an investment portfolio. Risk-averse investors can consider investing in government securities.

Do small-cap stocks pay dividends?

Since small-cap stocks offer higher growth potential than large cap companies, they may offer higher returns but also come at higher risk. These companies don’t usually pay dividends. Instead, the excess revenues are allocated towards enhancing growth

How do beginners buy stocks in India?

To begin investing in stocks in India, one must open a trading and demat account with a broker or a stock broking platform. An investor also needs to have a linked bank account to begin buying stocks.

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