Features of Small-Cap Stocks

The companies having the market capitalization below Rs 5,000 crores are called as small-cap stocks. Small-cap companies are relatively small compared to well-established businesses. However, they have high growth potential and can outperform large-cap stocks over the business growth and expansion. 

SEBI laid down criteria for classifying large-cap, mid-cap and small-cap stocks in 2017. As per the classification, large-cap stocks are those companies that rank 1st to 100th, mid-cap stocks rank 101st – 250th, and small-cap stocks rank 251st onwards in terms of total market capitalization.

What are the features of small-cap stocks?

Small-cap stocks include firms with low revenue and usually have a smaller workforce. Moreover, small-cap stocks are highly volatile and are a suitable investment for market-savvy investors.

The Growth Factor:

Small-cap stocks have the potential for a high growth rate and could become multi-baggers with time. These are stocks of businesses that are growing and rapidly expanding. Small-cap stocks allow investors to build wealth through capital appreciation over time. 

High Volatility:

Small-cap stocks are more vulnerable to corrections in the stock market than large-cap stocks. It is because small-sized companies have lower revenue streams than large established businesses. 

Moreover, larger businesses have well-diversified operations and good distribution networks than smaller firms. Small-size companies are likely to have negative cash flows during an economic slowdown making small-cap stocks extremely volatile. 

Investment Horizon:

Small-cap companies can become medium-sized businesses over time. However, you must be patient to realise gains in small-cap stocks. Market-savvy investors with a longer time horizon can look at small-cap stocks for higher returns. 

Low Liquidity:

Small-cap stocks have lower liquidity as compared to mid-cap and large-cap stocks. Fewer people trade in small-cap stocks compared to mid-cap and large-cap stocks. However, the liquidity of small-cap stocks may rise with better price discovery over time.

What are the risks associated with small-cap stocks?

Small-cap stocks are having low volatility as compared to large-cap stocks. Moreover, they are vulnerable to market risk, making them highly volatile during a stock market correction and event days. 

Market experts recommend that you do your research and pick small-cap stocks with solid fundamentals such as strong financials and excellent top management. Investors must decide on the proper allocation towards small-cap stocks in their portfolios. 

Who should invest in small-cap stocks?

Investors with a higher risk tolerance can invest in small-cap stocks. Moreover, you must thoroughly understand the small-cap segment before venturing into the investment. 

People with an investment horizon of over five years can invest in small-cap stocks. It takes time for the business to realize its true potential, and you must be patient to realize higher returns. 

Small-cap stocks can outperform mid-cap and large-cap stocks during a bull market. However, they can crash heavily during a bear market. You must be prepared for volatility in investments as small-cap stocks are high-risk investments. 

Investors must look for monopoly stocks in the small-cap space. These small-size businesses can withstand intense competition and generate strong cash flows as they have significant domestic market share. 

Things to check when picking small-cap stocks

Investors must pick small-cap stocks with solid financials such as strong cash flows, higher revenues and profit after tax. Moreover, it helps select companies with low debt on their balance sheet. 

You must pick small-cap stocks with a dominant market share. Moreover, these companies operate in a niche segment and enjoy significant entry barriers helping them out beat peers and rivals for some time. 

Investors must pick stocks of small-cap businesses with strong corporate governance. Good top management ensures stability in the industry and the potential to grow into medium-sized companies. 

Conclusion:

• Do not consider small-cap stocks as low-quality investments. consider small-cap stocks as an opportunity to multiply returns over time. 
• However, investors must pick up small-cap stocks if they understand the small-cap segment. Otherwise, it’s a risky investment as small-cap stocks crash during a stock market downturn. 
• Investors must diversify their stock portfolio across sectors and market capitalization. Do not invest only in small-cap stocks, maintain portfolio diversification

FAQs

How are gains from small-cap stocks taxed?

Small-cap stocks are taxed similarly to equity investments. After holding the investment for under one year, the short-term capital gains are taxed at 20%. However, long term capital gains after holding the investment for one year or more are taxed at 12.5% respectively.

What are the alternatives to small-cap stocks?

There are no alternatives Directly for small cap stocks, despite there are some other financial instruments which matches to the properties of small cap stocks in terms of risk & returns are mentioned below.

• Growth Stocks (Across All Caps)
• Startups or Private Equity Investments
• Small-Cap ETFs
• Real Estate Investment Trusts (REITs) Focused on Development or Niche Markets
• Junk bonds
• High yield Debentures
• Digital Assets
• Crypto currencies
• Art’s