What You Should Know About Investing In Small Cap Companies

When you hear the question “What is a small cap company?”, you might picture a business that’s just starting out. In India, the term refers to firms with relatively smaller market capitalisation compared to mid and large cap names. These companies get investor interest because they have a longer runway for potential expansion compared to more established players. However, they also come with higher volatility over the short-term and may not grow as expected.

In this article we discuss small cap companies in more detail and answer key questions for everyday Indian investors.

Table of contents

• Understanding small cap companies
• Investing in small caps
• Small cap mutual funds

Understanding small cap companies

To understand what small cap companies are, it helps to begin with how Indian regulators classify them. As per SEBI rules, the companies ranked 251st and beyond by market capitalisation on recognised stock exchanges are considered small cap companies.
When you invest in a small cap company, you are putting money into a business that is smaller or less established than those in the large cap or mid cap space.

Many of these also operate in niche or emerging domains. These smaller companies have some potential advantages: a relatively fresh business model, potential for rapid growth over time, and ability to carve out niche markets. For instance, many small cap companies may evolve into mid cap or large cap firms over time (subject to business execution and market conditions).
But the flip side is what makes small cap investing challenging. Because these companies are smaller, they often have less public visibility, fewer years of track record, and smaller balance sheets compared to large or mid cap peers. They also tend to be more vulnerable to downturns, competitive pressure, funding constraints, and liquidity issues. This may translate to higher volatility, liquidity risks, and greater vulnerability to market downturns or sector-specific challenges.

In simple terms, investing in a small cap company means accepting that you could be in for a slightly bumpier ride compared with investing in established companies. Because of that, two practical factors matter: your time horizon and your risk appetite. If the business scales, the long-term upside may be meaningful, but if not, the downside risk tends to be higher, especially over the short to mid-term.

Read Also: What Is Small Cap? Meaning, Risks & How to Invest

Investing in small caps

You may come across stories about small cap companies that grew rapidly and potentially made significant returns for early investors. While such examples may exist, finding them consistently is tough. Many emerging companies face challenges that only become visible once they try to scale. Here are some problems small caps may face:

• Access to capital: A small cap company may struggle to raise funds on favourable terms when markets get tight.
• Uncertain growth: A small cap company may show promise but translating that into sustained expansion involves multiple challenges: scaling operations, managing competition, securing capital, adapting to regulatory changes, and maintaining margin. Smaller firms may lack the cushion that large caps may possess when adversity hits.

• Competitive dynamics or regulatory disruption: Being small may mean less margin for error when rules change or competition intensifies.

• Liquidity and exit options: Because the stock market listing of small cap companies tends to be less deep and less widely traded, selling a large stake quickly may be harder which is an issue for mutual funds holding such stocks.
• Valuation risk: Because many small cap companies attract investor interest, valuations may get ahead of business fundamentals, potentially raising the risk of sharp corrections.

Because of these factors, investing in the small cap space may often require three things: careful company selection (sometimes similar to finding a needle in a haystack), patience (giving the company time to potentially grow), and a tolerance for volatility (being able to ride out downturns).

For investors, this may mean: if you allocate to small cap companies, you could treat the journey as a long-term one, don’t expect linear potential returns, remain aware of the possibility of setbacks, and keep your exposure to this space in line with your overall risk profile.

To wrap up, investing in such companies may sometimes yield potentially rewarding outcomes, but success is not guaranteed, and the path is seldom smooth. Understanding the unique risks, being patient, and incorporating small cap investments as part of a diversified strategy may be key.

Read Also: Small Cap ETFs: Meaning, Benefits, and Who Should Invest

Small cap mutual funds

Investors who wish to tap into the growth potential of small cap stocks but do not have the time or expertise to conduct the thorough analysis required may consider investing in small cap funds. Such funds invest predominantly in small cap stocks and are professionally managed. This means an investment professional handles research, stock selection and portfolio management. This may potentially offer better risk management compared to independent stock selection for investors without specialized market knowledge.

Moreover, mutual funds are diversified, so risk is spread across multiple assets.

FAQ’s

What are the risks associated with investing in small cap stocks?

The risks in investing in small cap companies include: higher volatility; business-specific risk since the company may be early in its growth phase; valuation risk where high expectations may already be priced in; and exit risk or redemption risk if many investors attempt to sell at the same time. Because of these risks, investors in small cap companies require a longer time horizon and comfort with short-term fluctuations.

How can investors identify promising small cap stocks?

While it is impossible to guarantee success, certain broad criteria may help when assessing a small cap company. These include: a clear business model with potential for scalable growth; a clean management track record; financial stability (manageable debt, good cash flows); and depth of market or niche advantage. Also consider how realistic the growth assumptions are and whether the valuation is reasonable. Even then, remember that each small cap investment carries risk and favourable outcomes are not assured.

What role do small cap stocks play in a diversified investment portfolio?

Small cap companies can offer a way to diversify beyond large cap or mid cap stocks. A measured allocation may enhance your portfolio’s long-term growth potential. That said, the exposure should be aligned with your risk tolerance and time horizon. If you include small cap companies, consider limiting the allocation to a portion you are comfortable with, and combine them with relatively stable investments for balance.