Stocks are categorized based on their market capitalization. The market capitalization of a company is defined as the product of its share price and the number of shares outstanding. At the current share prices, small-cap stocks generally have a market capitalization of less than ₹5,000 crore.
What are small-cap Stocks?
Securities and Exchange Board of India (SEBI) defines small-cap as "251st company onwards in terms of full market capitalization”, i.e. stocks from those companies that are ranked below 250 on the stock exchange in terms of market capitalization.
Small-cap stocks are considered to be highly volatile. This makes investing in small-cap stocks substantially more risky than investing in large- or mid-cap stocks. At the same time, small-cap stocks have the potential of generating high returns over the long term if you can identify the companies that would transition from small-cap to mid and large-cap stocks over the years.
Therefore, you should consider investing in small-cap shares only if your investment portfolio can absorb the volatility. Further, you should have an investment horizon of at least 7 to 10 years. Given the high risk-reward nature of investments made in small-cap stocks, they should ideally form only a small part of your overall investment portfolio.
How to buy small-cap Stocks?
If you are a beginner, the best way to invest in small-cap stocks is through small-cap mutual funds. Small-cap mutual funds are required to invest at least 80% of their corpus in small-cap stocks. If you do not have any small-cap stocks in your portfolio yet, you can use a systematic investment plan (SIP) or a systematic transfer plan (STP) to build your investments in this segment. You could also consider small-cap index funds and exchange traded funds.
A seasoned investor can look to invest directly into small-cap stocks after analyzing the fundamentals of the company of interest. As these are listed companies, all financial statements can be easily accessed online. You can use small cap stocks list available online for shortlisting stocks. Further, it is important to ensure that a good leadership team is in place before investing in such companies. All said, as a rule of thumb small-cap stocks should not make up more than 10% of your equity portfolio because of the high risk they carry.
Reasons to buy small-cap stocks
Huge growth potential
Remember that most large-cap companies started out as small businesses. Individual investors who were able to participate in their growth have managed to build substantial wealth over the years. Everyone wants to find the next multibagger, and those diamonds in the rough would be among the small-cap companies of today.
Underrepresented in mutual funds
Mutual funds like to buy a large number of shares from companies they invest in. Most small-cap companies are not a great fit for these as they have a limited number of shares available. This makes them an ideal candidate for individual investors who can spot a growth opportunity and invest before the mutual funds become interested.
Attractive valuation
Small-cap stocks fly under the radar of most analyst and Dalal Street pays them little attention. This under-reporting results in stocks being undervalued compared to large- and mid-cap stocks, keeping the small cap share price lower than its true value. That said, over the long term, the market valuation will reflect the true value of the company and an early investor can expect to book a large profit when that happens.
