Understanding small cap stocks: A guide for investors

Stocks offer a broad array of opportunities, but with so many choices available it can be overwhelming to decide where to begin investing. Among the different categories of stocks, small-cap stocks often stand out for their potential for growth—and their corresponding risks. If you're a beginner investor looking to explore this segment, this guide will help clarify what small cap stocks are, why they might appeal to investors, and how they compare to other types of investments.

• Table of contents

1. What are small cap stocks?
2. Features of small cap stocks
3. Reasons to invest in small cap stocks
4. Major advantages of small-cap stock
5. Associated risks of small-cap stock
6. Small cap stock vs. large cap stock

What are small cap stocks?

Small cap mutual stocks are essentially equity funds that allocate a significant portion (at least 65%) of their funds to stocks of small companies. Essentially, small cap stocks refer to the shares of companies with relatively small market capitalisations. The Securities and Exchange Board of India (SEBI) establishes the list of top companies and sets the rules for the investment portfolios of different funds. Small cap stocks are those listed 251 and beyond on the stock exchanges.

Fund managers actively seek out these small-capitalisation stocks, which consistently perform in the market and, at times, outperform benchmark indices and large-cap stocks.

Features of small cap stocks:

• Higher growth potential: Small cap companies have room for expansion, potentially leading to strong returns.
• Volatility: These stocks can fluctuate more than large cap stocks, offering both gains and sudden declines.
• Limited financial resources: Small companies often lack the financial stability of larger ones, making them more vulnerable to economic changes.
• Liquidity challenges: Small cap stocks are less liquid, meaning large trades can influence their market price.

Reasons to invest in small cap stocks

Investing in small cap stocks can be appealing for several reasons:

1. Growth opportunities: Small cap stocks are often in the early stages of their business cycle, meaning they have more room to grow. Investors willing to take on the higher risk may find this potential particularly enticing.
2. Innovation: Smaller companies are often more innovative and flexible, allowing them to pivot quickly and take advantage of emerging trends or new technologies.
3. Attractive valuations: Small cap stocks are often undervalued compared to larger stocks, presenting opportunities for long-term investors willing to conduct research and purchase stocks at discounted prices.
4. Diversity in portfolio: Adding small cap stocks to your portfolio provides diversification. These companies usually have less correlation with large cap stocks or the overall market, which can help mitigate your portfolio’s overall risk.

Major advantages of small-cap stock

Small cap stocks come with a range of benefits for investors who are prepared to manage the risks involved:

1. Higher growth potential: As previously mentioned, the biggest advantage is the potential for high returns. Small cap stocks have historically delivered higher returns than their larger counterparts. However, past performance may or may not be sustained in the future.
2. Undervalued opportunities: Small cap stocks can often be overlooked by institutional investors, leading to undervaluation opportunities. For patient investors, this presents an opportunity to purchase stocks at a low price before they catch the market's attention.
3. More aggressive management: Smaller companies often have management teams that are eager to prove themselves, leading to more aggressive and innovative strategies that drive growth.
4. Increased demand for stocks: As small companies grow, they may get interest from larger institutional investors, which can drive up their stock price. Investors who get in early can benefit from this upward momentum.

Associated risks of small-cap stock

However, like any investment, small cap stocks come with their risks:

1. Volatility: Small cap stocks are often much more volatile than large cap stocks, which means their prices can fluctuate wildly over short periods. This makes them an extremely risky investment, especially for those with a lower risk tolerance.
2. Liquidity issues: As mentioned, small cap stocks tend to be less liquid. This means that buying or selling large quantities may have a more significant impact on the stock price.
3. Financial instability: Many small companies lack the financial stability of larger companies, making them more vulnerable to market fluctuations or economic downturns.
4. Less public information: Small cap companies often don’t have the same level of analyst coverage or public information available, which can make it harder to assess their financial health and growth prospects.

Small cap stock vs. large cap stock

When comparing small cap stocks to large cap stocks, the key differences are clear:

1. Risk and return: Small cap stocks come with much higher risk but also the potential for higher returns. Large cap stocks, by contrast, are typically more stable but offer lower growth potential.
2. Stability: Large cap stocks tend to be relatively stable due to their established track record and the size of the company. Small cap stocks are often in earlier stages of development, which can lead to more erratic performance.
3. Liquidity: Large cap stocks are much more liquid than small cap stocks meaning investors can buy and sell large quantities without significantly affecting the market price.
4. Market influence: Large cap stocks are often part of well-known market indexes, and their performance is closely followed by analysts and investors. Small cap stocks may be less widely tracked, but they can offer significant growth potential for those who are willing to research and monitor them closely.

Small cap stock indices

There are several stock indices that track the performance of small-cap stocks serving as benchmarks to measure the overall performance of the small-cap segment in the market. Some examples of Indian indices include:

NSE Small-Cap Indices:

• Nifty Smallcap 100 – Tracks the top 100 small-cap companies based on market capitalization.
• Nifty Smallcap 250 – Covers the top 250 small-cap stocks from the Nifty 500.
• Nifty Smallcap 50 – A subset of Nifty Smallcap 250, including the top 50 liquid small-cap stocks.
   

BSE Small-Cap Indices:

• BSE SmallCap Index – Represents the small-cap segment of BSE, covering a large number of small-cap stocks.
• BSE 250 SmallCap Index – Tracks the performance of 250 small-cap companies from the S&P BSE 500.
• BSE Smallcap Select Index – Measures the performance of the 60 largest, most liquid companies within the BSE SmallCap.

Conclusion:

Small cap funds offer a thrilling entry point to the world of high growth potential and exciting returns. However, their inherent risks and volatility demand careful consideration and thorough research. By understanding features and benefits of small cap stock, assessing your risk tolerance, and practicing smart investment strategies, you can harness the power of small cap mutual funds to unlock a rewarding investment journey. Always remember to consult a financial advisor for tailored small cap stocks investing advice.

FAQs:

Are small cap funds suitable for everyone?

No, small cap funds are not for everyone. Their high volatility and risk profile make them suitable only for investors with a high-risk tolerance and a long-term investment horizon.

How much should I invest in small cap funds?

The amount you invest in small cap funds should be based on your individual risk tolerance and overall portfolio allocation. It's generally advisable to limit your exposure to small cap funds to a smaller percentage of your portfolio.

Should I invest in a single small-cap fund or diversify across multiple funds?

Diversifying across multiple small-cap funds with different investment styles and industry focuses can help mitigate risk and enhance your long-term returns.

Mutual Fund investments are subject to market risks, read all scheme-related documents carefully.
This document should not be treated as endorsement of the views/opinions or as investment advice. This document should not be construed as a research report or a recommendation to buy or sell any security. This document is for information purpose only and should not be construed as a promise on minimum returns or safeguard of capital. This document alone is not sufficient and should not be used for the development or implementation of an investment strategy. The recipient should note and understand that the information provided above may not contain all the material aspects relevant for making an investment decision. Investors are advised to consult their own investment advisor before making any investment decision in light of their risk appetite, investment goals and horizon. This information is subject to change without any prior notice.