Small Cap Stocks

Sannihitha Ponaka •

Updated on 1 Nov, 2023

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6 Mins

Article Content

What are Small Cap Stocks?
Features of a Small Cap Stocks
Advantages and Limitations of Investing in Small Cap Stocks
Who Should Invest in Small-Cap Stocks?

What are Small Cap Stocks?

Small cap stocks in India are shares of companies whose market capitalisation is less than INR 5,000 crore. These companies, for the most part, aren’t very well known and do not have a long track record. Small-cap companies are companies that are in their early development stages.

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These businesses are smaller in size but have good potential for expansion. The fact that they are fairly new, with not much track record, and a low chance of succeeding over time makes them risky investments. As a result, small-cap stocks are highly volatile.

Since small-cap stocks are highly volatile, the share prices tend to fluctuate to small market corrections as well. In a bull market phase, small-cap stocks have the potential to generate significant returns. At the same time, the possibility of negative returns is also very high during a market downtrend.

Features of a Small Cap Stocks

Following are the features of small-cap stocks:

Growth Potential

Small-cap stocks are emerging businesses that are fairly new and in their early development stages. Thus, the scope for them to become bigger and grow is high. The companies have the potential to become the next mid-cap companies and, subsequently, large-cap companies. Hence, the opportunities are quite vast for small-cap stocks.

Volatility

Small-cap stocks are highly volatile, and their prices move swiftly with market swings. These stocks, for example, outperform when the market is bullish but underperform when the market is down. Since small-cap companies are reliant on the market, they are vulnerable to market changes. Thus, these stocks have a high probability to lose their value during market downturns and take longer to recover from it. Thus, making them a risky investment option.

Furthermore, small-cap companies have fewer revenue sources than large-cap companies. Large-cap companies have a more diverse business and can expand into new businesses. Similarly, mid-cap stocks are more established, with higher cash flow, capital and a diverse range of products and services than smallcap stocks.

Returns

Small-cap stocks are among the highest-yielding investing options available. Thus, small cap stocks have a high potential to become multi-baggers, with more than 100% returns. Smallcap stocks have a good potential to generate wealth. Thus, making them a desirable investment option. Choosing the correct stocks and holding them for the long term can pay out handsomely in terms of returns and capital appreciation. They are frequently referred to as multi-baggers since they can provide significantly higher returns than mid-cap and large-cap stocks.

Liquidity

Small-cap stocks are less liquid in comparison to large-cap and mid-cap stocks. They have less liquidity since they are less well-known. Thus, it becomes difficult to buy and sell.

Investment Horizon

Since smallcap stocks are highly volatile, they are suitable only for long term investments. The market movements drastically impact the small-cap share prices. Thus, to average out the volatility and be able to generate significant returns, a long term investment horizon is necessary.

Price

Small-cap stocks have a smaller market capitalization and number of outstanding shares in comparison to large and mid-cap stocks. The share price of smallcap stocks is likely to be lower. The undervaluation is due to the companies’ under-recognition in inefficient markets. Thus, capital appreciation will be high when investing in the right stock. Furthermore, smallcap stocks have a faster organic growth rate than large-cap and mid-cap companies.

Advantages and Limitations of Investing in Small Cap Stocks

Advantages

Following are the advantages of investing in small-cap stocks:

Growth Potential

Small-cap companies often have a higher organic growth rate than large-cap and mid-cap companies. The opportunities to grow and develop businesses are high for small-cap companies. This factor favours small cap stocks and boosts their growth potential significantly.

Price

When it comes to investing in the best small cap stocks, major institutional investors must comply with specific restrictions. Thus, it limits their ability to drive stock prices higher. Retail investors can thus benefit from the lower prices of the stocks, and enjoy higher capital appreciation.

Furthermore, small cap stocks are undervalued due to possible market inefficiencies. With in-depth research and market analysis, investors can profit from such inefficiencies by purchasing high-quality equities at a low price.

Limitations

Following are the limitations of investing in small-cap stocks:

Risk

Small-cap stocks are highly susceptible to market movements. Thus, the investments are highly volatile. This is the most significant risk associated with small cap stock investments. As a result, before investing in small-cap stocks, one must conduct thorough research, make appropriate asset allocation decisions and have a long term investment horizon.

Liquidity

In comparison to large-cap and mid-cap stocks, small cap stocks are less liquid. Since small-cap companies are not well known, the trade volumes are lower. Therefore, sometimes it can be challenging for investors to liquidate their investments instantly.

Information

Small cap stocks are not well-known companies. Unlike large-cap and mid-cap companies, information about small-cap companies is not easily available. Thus, one needs to perform in-depth due diligence about the company, its management, business operations, etc., before investing in it.

Who Should Invest in Small-Cap Stocks?

Large-cap companies are at the top of their growth curve, and the most significant gains in their history may be coming to an end. They frequently purchase new businesses, usually smaller ones, in order to expand and enter new industries.

The mid-cap companies are more solid and established than the small-cap stocks because they are in the middle of the growth cycle. Small cap stocks are different from their larger counterparts in terms of risks and returns.

Since small cap companies are not well known, thorough research is required before investing in a stock. Small cap stocks are appropriate for investors with high-risk tolerance levels and long term investment horizon. The stocks tend to fluctuate with small market movements, and thus one needs to be patient with their small cap stock investments.

Furthermore, small cap stocks have the potential to generate high returns in favorable market conditions. However, you must be mindful of the price volatility as well. Small cap stocks are high risk and high return investments.

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