Small cap stocks are like the backbenchers in a class. The faculty has very little expectations from them. Their chances of becoming class topper are low. But not impossible. Similarly, small cap stocks are at the bottom of an investor’s buy list. They are considered to be risky bets as they belong to lesser known companies. Ideally, only highly aggressive investors should invest in small cap stocks.
While small cap stocks are volatile, they do provide wealth creation opportunities. Imagine being an early investor in United phosphorus limited (UPL) in 2004, its share price was Rs. 29. Today its share price is Rs 740. UPL has generated a compounded annual growth rate (CAGR) of 21%. It is no longer a small cap stock. It is now a large-cap stock with market capitalisation of Rs 53,124 crores and even part of the Nifty 50 index.
Every large cap stock we see today was once a small cap or mid cap stock. To create wealth, you need to discover such superior small cap stocks and hold them for the long term.
In this article:
What are small cap stocks?
List of best small cap stocks
Characteristics of a small cap stock
What should you look for before investing in a small cap stock?
Alternatives of investing in a small cap stock
So, let’s begin.
What are Small Cap Stocks? – Definition of Small Cap Stocks
Market capitalisation simply means the total value of a company’s shares. It is calculated by multiplying outstanding shares by current share price of a company. So, if a company has 20,000 outstanding shares in the market each priced at Rs 20. The market capitalisation of the company is Rs 4,00,000.
Recommended reading: What is market capitalisation with examples?
The market capitalisation of small cap companies is generally less than Rs 5,000 crores. Small cap stocks have the potential to deliver superior returns in the long term. But they are incredibly volatile and are riskier than large cap and mid cap stocks.
There are two main small cap indices in India. These help investors gauge the overall trend of small cap stocks.
Nifty Small Cap 50 index consists of the top 50 most traded small cap stocks in the market. Whereas S&P BSE Small Cap index represents about 900 small cap stocks in the market.
List of Best Small Cap Stocks in India – As of June 2021
*This is simply the list of best small-cap stocks. This is not investment advice.*Current market price as on 27th October 2021
Characteristics of Small Cap Stocks
1. High Volatility
Small cap stocks belong to less stable companies and hence they are highly volatile. They underperform large and midcap stocks in a bear market. But small cap stocks are outperformers in a bull market.
2. High Risk
Small cap stocks belong to lesser known companies having limited cash reserves. So they are more likely to have negative cash flows during economic slowdowns. Due to this, small cap companies have a greater chance of going bankrupt during economic contractions.
3. Superior Growth Potential
Risk and returns goes hand in hand. Small cap stocks are highly risky. But they also provide superior growth. For example: Delta Corp Ltd is one of the best small cap stocks in India. In March 2020, it was trading near its 52-week low at Rs 59.39. Today its stock price is Rs 265. It has generated a CAGR of 145.34% in the last 1 year! Such growth opportunities are not available in large-cap stocks.
4. Low liquidity
Small cap stocks are generally less liquid compared to large and midcap stocks. This is because very few investors trade in small cap stocks. However, a stock can become liquid over time with better price discovery and broader stock ownership.
Historical Performance of BSE Small cap vs Sensex
What Should You Look at Before Investing in Small Cap Stocks?
1. Financial strength of the company
The share price of a company rises when it has a sound financial background. While analysing the financial strength of a company you must look for:
A company with strong balance sheet and stable financial ratios have high growth potential against its peers.
2. Rising sales and profits
Small cap companies have low cash reserves. They are heavily dependent on their sales. Hence, before investing in a small company you must check its sales and profit numbers for at least 5 years. Rising sales can help the company grow quickly. High profits help the company improve its income and margins through cost optimisation. A company with consistent growth can provide good returns to its investors in the long term.
3. High operating margin
Operating profit margin measures the profitability of a business.
This ratio helps us understand how much percentage of profits the company generates from its operations before paying taxes and interest. A company with consistently increasing operating profit margin can prove to be a good investment opportunity.
4. Quality of management
Small cap companies do not have much room for error. Even a small management error can spell doom for them. Hence investors should do a thorough background check of the company’s promoters and management before investing.
Check out our video on how you can identify the best small cap stocks to buy in India.
Alternatives to Investing in Small Cap Stocks
Investing in small cap stocks involves huge risk. Hence, you must include large cap and mid cap stocks to balance your overall portfolio. But selecting one or two small cap stocks from more than 250 stocks is difficult. Instead investors can invest in small cap mutual funds. They help in portfolio diversification, and are professionally managed by experts.
Small cap mutual funds invest 80% of their corpus in stocks of small cap companies. The remaining 20% is invested in large cap or midcap stocks. In the long run, small cap mutual funds have outperformed large and midcap mutual funds.
Historical Returns Provided by Mutual Funds
List of Best Small Cap Mutual Funds in India for 2022
*This is simply the list of best small cap funds. This is not investment advice.
To conclude, small cap stocks are volatile in the short term. But to create wealth, you need to be patient and never let short term volatility affect you. So, invest in the best small cap stocks, by opening a FREE Demat account with Samco – India’s best equity stockbroker and get brokerage cashback on all trades placed by the Samco App for the first month!
Happy investing
The author has done a Bachelors in Banking and Insurance (BBI). She is a budding financial content writer. Her strength lies in simplifying financial jargons. Her goal is to help readers make better investment decisions.
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