Small-Cap Stocks

This article talks about small-cap stocks, their features, their advantages, the risk associated with them, and other alternative investment options.

Small-Cap is used to describe a company with relatively small market capitalization. A company’s market capitalization is defined as the market value of its outstanding shares. In India, the Securities and Exchange Board of India (SEBI) defines small-cap as companies ranked beyond 251 as per their market capitalization. Generally, a company with a market capitalization below Rs. 5000 crores are classified as small-cap companies. Small-cap stocks refer to stocks of small-cap companies that are publicly traded on the stock exchange. Small-cap stocks are recommended to those individuals who are willing to take high risks and are seeking higher returns. Small-cap stocks are generally volatile in nature and are prone to market risk. The NIFTY Small Cap 100 Index considers the performance and behavior of small-cap stocks in the market. It comprises 100 stock exchange-traded companies.

Features of Small-cap Stocks

  • Volatile: The market price of these stocks is heavily influenced by market fluctuations. These stocks tend to outperform other sized stocks during the high market phase but underperform when the market is struggling.
  • Risk: As small-cap stocks are volatile in nature; they are risky investment options. Small-cap stocks depend highly on the market, making it open to fluctuations. These stocks are susceptible to be affected by market recessions.
  • Returns: Given the high risk of these stocks, they are counted among the top-yielding investment options. They have huge upside potential and can emerge as a multi-bagger investment.
  • Investment Horizon: Individuals can invest in small-cap stocks for any time horizon. Although in India small-cap stocks can be traded for both short-term and long-term, it is advisable that investors trade in these stocks for a long time horizon to spread their risk and to generate substantial returns.
  • Low Liquidity: Small-cap stocks are generally less liquid as compared to mid and large-cap stocks due to a smaller number of investors trading in small-cap stocks.

Advantages of Small-Cap Stocks

Individuals investing in small-cap stocks can avail themselves the following advantages given he carefully selects his stocks:

  • High Growth Potential: Risk and rewards go hand in hand. As small-cap stocks are risky in nature, they also provide superior growth potential. Compared to large-cap and mid-cap companies, small-cap stocks have better growth potential and opportunities. Small-cap companies can grow and acquire capital in due time which enhances their growth potential to a great extent.
  • Fairly Priced: There are certain limitations in place when it comes to investing in small-cap stocks by major institutional investors. It restricts their power to push stock prices upwards. This allows small retail investors to trade small-cap stocks at fair prices.
  • Low-priced quality stocks: Small-cap companies are often under-recognized and are thus undervalued. Investors can benefit by identifying and exploiting these price inefficiencies with little research. They can acquire quality stocks at lower prices and earn greater returns on their investment.

The risk associated with Small-Cap Stocks

Small-cap stocks come with a huge risk burden. This investment option is not suited for risk-averse or conservative investors. Some of the common risks associated with small-cap stocks are:

  • These stocks are highly susceptible to market risks and fluctuations, which can only be mitigated to some extent through long-term proper asset allocation and portfolio balancing.
  • These stocks are less liquid, which makes it difficult for investors to sell these stocks as per their requirements at favorable terms.
  • There is a large number of small-cap stocks traded on the stock exchange. Not all these stocks offer great growth potential. Investors require time and research to determine these stocks and identify the best investment avenues.
  • Small-cap companies are relatively new entrants in the industry which means their business may be unsteady and companies may be affected by external factors. Access to new capital for such a company is very difficult, which leads to a high cost of borrowings and higher risk for investors.

Alternative Investment Options

As investing in small-cap stocks involves huge risk, investors who do not have a high-risk appetite can opt for less risky investment options. Other investment avenues for investors are:

  • Large and Mid-cap Stocks: The shares of the company ranked in the top 100 and shares of the company ranked between 100-250 as per market capitalization are known as large-cap and mid-cap companies respectively. These stocks are less prone to market risks and fluctuations. Investors with less risk appetite should invest in these stocks.
  • Hybrid Funds: Low-risk appetite investors can also opt for hybrid funds. These funds offer a mix of both equity and debt. These funds provide further diversification within equity and debt. It allows investors to diversify their investments to spread and mitigate risk.
  • Government securities: These are debt instruments issued by the government and hence are for risk-averse individuals looking for steady and riskless returns.
  • Mutual Funds: Investors can opt for different forms of mutual funds as per their risk appetite and return expectations.