Features of Small-Cap Stocks & How to Pick Small Cap Stocks

Updated on: May 10th, 2022

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6 min read

Small-cap companies have a market capitalisation below Rs 5,000 crore. The stocks of these companies are called 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 during a stock market rally. 

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 capitalisation.

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 illiquid as compared to large-cap stocks. Moreover, they are vulnerable to market risk, making them highly volatile during a stock market correction. 

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 realise its true potential, and you must be patient to realise 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 view small-cap stocks as low-quality investments. On the other hand, look at small-cap stocks as an opportunity to earn higher 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 capitalisation. Do not invest only in small-cap stocks, or your stock portfolio will crash heavily during a market correction. 

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 15% with applicable cess. However, long term capital gains after holding the investment for one year or more are taxed at 10% on gains above Rs 1 lakh.

What are the alternatives to small-cap stocks?

Investors who are not comfortable with small-cap stocks can consider investing in mid-cap and large-cap stocks. However, after understanding the investment, you can study the small-cap space and invest in small-cap stocks, provided you have higher risk tolerance. 

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Quick Summary

Small-cap companies have market capitalization under Rs 5,000 crore, are highly volatile, and suitable for market-savvy investors. They have high growth potential but come with risks, thus demanding solid research and understanding before investing. Investors should have a longer time horizon and higher risk tolerance for investing in small-cap stocks.

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