What are Small-Cap Stocks: Features, and Advantages

5 mins read
Hey, stock enthusiasts! Before making investment decisions learn if you should have small-cap stocks in your portfolio

For anyone who wishes to understand the stock market and trade in it, grasping the concept of market capitalisation is critical. Market cap, which is short of capitalisation, determines the value of a company. Based on market capitalisation, stocks are large-cap, mid-cap, and small-cap. Investors need a clear understanding of stock categories to plan their portfolios effectively. According to market classification, small-cap stocks are from companies with a market capitalisation of less than Rs 500 crore. 

What determines market capitalisation?

Technically, 95 percent of Indian companies are small-cap. To answer the question: ‘what are small-cap stocks?’ we must understand market capitalisation.

Market capitalisation is an estimation of the total worth of a company. It refers to the aggregated value of all company stock shares. It is measured by multiplying the price of a stock with the total number of outstanding shares. For example, a company with 100,000 shares trading at Rs 120 has a market capitalisation of Rs 1,20,00,000. 

Market capitalisation is important for investors. It allows investors to size up the company before they invest and depicts how valuable investors think the company is. The higher the value, the bigger the company. 

For prospective investors, the size and value of the company is an estimation of the risk level they might expect while investing in the stocks. 

Companies are classified as small-cap when they have a market cap of Rs 500 crore or less. In the stock exchanges list of stocks, the first 100 companies are large-cap, between 101-250 are mid-cap, and companies listed from 251 and below are small-cap companies.

What are small-cap stocks?

Small cap stocks are shares from small companies publicly traded on the stock exchanges. Investors must understand small-cap stocks meaning and the risks associated with investing in small-cap stocks. 

Small cap stocks are attractive to investors who want to earn high returns on their investment. These stocks are from new companies with small market capitalisation. As a result, they are highly volatile and suit investors with a high-risk tolerance. Investors can cushion against the risk from small-cap by diversifying their portfolio and adding market-friendly investments.   

Features of small-cap stocks:

Investors who want to invest in small-cap stocks should know the following features.

  • Volatility:

    Small cap stocks are highly influenced by market fluctuations, making them volatile. These stocks perform well when the market is an uptrend and underperform when the economy is down.

  • Risk factor:

    Small-cap stocks are risky because of their susceptibility to market fluctuations. 

  • Returns:

    Small-cap stocks are among the top yielding stocks with the ability to generate multifold returns.   

  • Cost of investing:

    Investment charges vary between the brokers. Besides the initial investment fees, investors must also bear the expense ratio on investments.

  • Investment horizon:

    Small-cap is an equity investment and tends to perform while invested in the long run. 

  • Taxation:

    Returns generated while redeeming the shares are taxed as per Capital Gain Taxation Rules as Short-term Capital Gain and Long-term Capital Gain. 

Major checklist before investing in small-cap:

  • • Considering the company’s past performance is often the key to judging the stability of mid-cap and small-cap companies. And by past performance, we mean 4-5 years of performance.
  • • Small-cap companies are highly heterogeneous, so the bottom-up investing approach works better for them.
  • • The primary purpose of investing in small caps is to generate significant returns or above-average market returns (alpha).  
  • • Consider factors like the company’s ability to manage its working capital, stability and quality of its management team before investing. The objective is to find the next multi-bagger investment.
  • • Analyse the risk of their business model. Some businesses are riskier than others, like NBFCs, and MFIs can take undue risk.
  • • The soundness of a company’s foundation is tested during bad economic conditions. Your choice of stocks, therefore, should be based on the company’s stability during bad market conditions.
  • • Growth margin and profit margin are two significant determiners of the future trajectory of its share price.
  • • Lastly, consider the stock’s liquidity and basis risk. Shares, especially small-cap shares, are best avoided if there isn’t enough liquidity.

Pros and cons of investing in small-cap stocks:

Pros  Cons 
Small-cap companies have a better organic growth rate.  These stocks are susceptible to market risks.
The market mechanism prevents large investors from pushing the stock price and allows small investors to buy small-cap shares at a fair price. These are comparatively less liquid than large-cap shares.
Small-cap stocks are often under-recognised and often under-priced. So, there are chances to avail of quality stocks at a low price. They need time and extensive research to discover potential stocks.

Small-cap stocks are often under-recognised and often under-priced. So, there are chances to avail of quality stocks at a low price.

Needs time and extensive research to discover potential stocks.

Alternative investments:

Small-cap stocks are not for everyone. Because of their high-risk nature, small-cap stocks are suitable for aggressive investors. If you don’t have a high-risk appetite, there are other investment alternatives to generate significant returns. 

  • Large-cap companies:

    Large-cap stocks are less susceptible to market fluctuations and offer stable returns to investors over the years.

  • Hybrid funds:

    Investors can also explore them to generate balanced portfolio returns. 

  • Government securities:

    Government securities are debt instruments that offer risk-free yields on investment.

Major takeaways:

  • • Small-cap stocks are from companies with a market capitalisation of Rs 500 crore or less.
  • • They are attractive to investors because of their potential to earn above-average market returns.
  • • Small-cap stocks tend to perform well during a market uptrend and lose their value quickly during downtrends, making them highly unstable.
  • • Small-cap stocks are volatile and hence, are highly risky. 
  • • These stocks are best suitable for aggressive investors with a high-risk appetite.  
  • • It requires extensive market research to discover potential small-cap stocks.

Conclusion:

Whether investing in large-cap or small-cap companies, you should always opt for investment avenues that suit your requirements and financial standings. Now we have explained small-cap stocks to find the best suitable investment options for yourself. Open an Angel One Demat account and start investing.