What are Small-cap Stocks? Advantages and Risks Explained

Stock market investors must familiarise themselves with the concept of market capitalisation. Market cap, which is short of market capitalisation, is a measure of a company’s value. Basis market cap, stocks are commonly divided into large-cap, mid-cap, and small-cap. 

Small-cap stocks have a market capitalisation of less than Rs 5,000 crore. These companies are ranked above 251 and beyond. Nearly 95% of stocks in the Indian market can be classified as small-cap stocks. In this article, we will explore the features, benefits and risks associated with investing in small-cap stocks. 

What are Small-cap Stocks?

Small-cap stocks as the name suggests are shares of smaller companies listed on the stock exchange. These are young companies with a high growth potential. 

If you are looking for sharp capital appreciation, then small-cap stocks can be a suitable investment option. However, only risk-savvy investors should invest in small-cap stocks as they are highly volatile and can fall sharply when stock markets crash.  

Indian stock market has a benchmark for small-cap stocks called the Nifty Small-cap 50. This index on the NSE tracks the 50 most-traded small-cap companies. 

Features of Small-cap Stocks

While small-cap stocks can offer substantial returns they also carry huge risks. Before investing in the best small-cap stocks, investors should understand their features:

Risk Tolerance: Small-cap stocks are highly volatile. They are influenced heavily by stock market fluctuations. Small-cap stocks perform better when the markets are rising but may be deeply affected by stock market downturns and take a long time to recover. This makes small-cap stocks a risky investment. 

Returns: Small-cap stocks can offer you massive returns. They have the potential to turn multibaggers, giving over 100% gains. 

Longer Investment Horizon: Small-cap stocks are ideal from a long-term perspective. Holding for a long period can help you ride out short-term volatility associated with small-cap stocks and generate strong returns. 

Low Liquidity: Small-cap stocks have lower liquidity than mid-caps and large-caps due to lesser volume and asset base. It is challenging to buy or sell small-cap stocks, especially during market downturns, which increases the risk of losses and may result in lost opportunities. 

Dependence on Market Conditions: The performance of small-cap stocks is also linked to the economic environment. Investors should assess the macroeconomic conditions and market mood before buying small-cap companies.

Who Should Invest in Small-cap Stocks?

Investing in small-cap stocks is best suitable for the following investors:

• Investors looking to make substantial gains on their investments as these companies are young and upcoming, with a sharp runway for growth.
• Investors with a long-term horizon as small-caps can generate better returns in the longer run while minimising the impact of short-term volatility.
• Investors with a high-risk tolerance as small-cap stocks are susceptible to high volatility and fluctuations.

Advantages of Investing in Small-cap Stocks

Investing in the best small-cap stocks can offer the following advantages to investors:

High Growth Potential: Compared with large-cap companies, small-cap companies have the potential to provide higher returns as they can grow at a faster pace than their larger peers. This aspect makes them attractive to investors. 

Low Institutional Attention: Small-cap stocks may be overlooked by institutional investors like FIIs and DIIs as they face certain limitations while investing in them. This creates opportunities for retail investors to buy undiscovered small-cap stocks at fair value. 

Low-priced Quality Stocks: Most small-cap stocks are under-discovered, making them available at lower prices. Investors can thoroughly analyse them to pick low-priced quality stocks.

Risks of Investing in Small-cap Stocks

Here is a look at the risks involved with investing in small-cap stocks:

High Risk: Small-cap stocks offer substantial growth potential but come with higher risk compared to large-cap stocks. These companies are more vulnerable to financial challenges due to lower profitability, market share, and limited access to capital than their larger peers.

Low Liquidity: Small-cap stocks have lower liquidity than large-cap stocks. Investors may find it difficult to sell their holdings, which could result in losses.

Less Tracked: Most small-cap companies are not actively tracked by market analysts. As an individual investor, you will need to extensively research these companies to spot potential stocks. 

Alternative Investment Options to Small-cap Stocks 

Small-cap stocks may not suit all investors. Given their risky nature, more conservative investors can consider the following investment options that can also generate significant returns.

Large-cap Stocks: Investing in large-cap stocks can provide investors with stable returns along with dividend income. These companies are ranked among the top 100 on the stock exchange and are also less prone to market volatility. 

Hybrid Funds: These funds have a mix of both debt and equity. Hybrid funds are a great alternate investment plan for those looking to reduce risk, and earn assured returns.

Government Securities: These are bonds issued by the government. Investing in government securities can help you earn assured returns, and suit risk-averse investors. 

Conclusion

Small-cap stocks are companies that are small in size but have great growth potential. Investing in small-cap stocks can result in sharp capital appreciation. However, one must remember that they are risky investments. Therefore, it is important to do proper research, understand one’s risk profile and consult a financial advisor before investing in small-cap stocks.

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