Introduction to Small Cap Stocks

by Siddharth Singh Bhaisora

Published On June 30, 2023

In this article

For the intrepid investor seeking to maximise their returns, small cap stocks can prove to be an enticing avenue. Furthermore, individuals unphased by market volatility and possessing a high-risk tolerance often find these investment opportunities quite appealing.

The inherent nature of small cap stocks does tend towards volatility, making them susceptible to market downturns. However, an astute investor can mitigate these risks by diversifying their portfolio with market-friendly investments, thereby creating a safety net around their small cap stock investments.

What are Small Cap stocks?

But what exactly are small cap stocks? Essentially, these are shares representing ownership in small cap companies that are traded publicly on a stock exchange.

In the vast expanse of the Indian stock market, companies boasting a market capitalisation of less than Rs. 5,000 Crore are classified by Securities and Exchange Board of India (SEBI) as Small Cap companies. Amazingly, these small cap businesses constitute over 95% of all Indian companies, showcasing the diversity of our economic ecosystem.

Such companies, typically ranking above 251 in terms of market capitalisation, are known to perform admirably during the early stages of economic recovery. Their publicly traded shares are what we refer to as small cap stocks.

The world of small cap stocks is filled with potential, but it also comes with unique challenges. Let's delve into the defining characteristics of these dynamic investments.

The Intricacies of Small Cap Stocks

  • Market Volatility: The prices of small cap stocks sway dramatically with market movements. They often shine brightly in a thriving market but can dip during market downturns. This volatility can be a boon or bane, depending on the timing of your investment.

  • Risk Quotient: The fate of small cap stocks is tied closely to the stock market, making them more vulnerable during market recessions. While they do recover, the journey back can be lengthy, thereby adding to their risk profile.

  • High Returns: Despite their riskiness, small cap shares stand among the most lucrative investment options. Their potential to deliver soaring returns, often exceeding 100%, earns them the badge of potential "multi-baggers."

  • Investment Horizon: You can dip your toes in small cap stocks for short-term or long-term investments. However, opting for a longer investment horizon can spread out the associated risks and potentially yield substantial returns.

  • Tax Implications: The profits from selling small cap shares are considered income under Section 80C. Short-term capital gains tax of 15% applies if you held the shares for less than a year. In contrast, long-term capital gains tax of 10% applies if the shares were held for more than a year.

Why Should You Consider Small Cap Stocks?

Small cap stocks are a category of stock investments that consist of stocks from smaller companies. They possess distinct characteristics that set them apart from large cap and mid cap stocks. Investing in smaller companies offers several advantages such as -

1. Inherent Growth Potential

Small-cap firms usually harbour significant growth prospects. Large cap companies have already experienced substantial growth and may have limited room for further appreciation in share prices. Conversely, smaller companies have the potential for significant growth and price appreciation in the years ahead. Investing in small cap stocks allows individuals to seize opportunities early on with emerging companies. By purchasing and holding shares of smaller companies, investors can benefit from potential future growth and value appreciation. If the company succeeds, it may eventually transition from small cap to large cap status.

2. Higher return potential

Market inefficiencies may offer high-quality smallcap stocks at more affordable prices. While large cap companies can provide stable returns and potentially offer income through dividends, small caps historically outperform larger companies in terms of average annual returns. Smaller companies tend to be more agile than their larger counterparts, allowing them to adapt quickly to market cycles, introduce new products or services, or undergo internal restructuring as needed. These factors contribute to the potential for small cap stocks to deliver better performance within their specific market segment compared to larger competitors.

3. Less competition from Institutional Investors

Institutional investors, such as banks, hedge funds, and real estate investment trusts, often overlook small cap stocks due to their size. Additionally, regulatory restrictions restrict these investors from heavily investing in small caps. This creates an opportunity for individual investors to enter the market and potentially witness the growth of small companies over time.

Upside of Small Cap Stocks

  1. Growth Prospects: Compared to large-cap companies, small cap ones often exhibit higher organic growth rates. This potential for expansion boosts their attractiveness.

  2. Competitive Pricing: As major institutional investors face restrictions on small cap stock investments, these shares often maintain fair prices.

  3. Value Opportunities: Small cap companies often go unnoticed, and their stocks underpriced. Market-savvy investors can seize these opportunities to snap up quality stocks at a discount.

Risk Factors to Consider

Investing in small cap stocks isn't without its challenges. Here are some potential roadblocks:

  • Market vulnerability: Small cap stocks can be susceptible to market upheavals, though strategic asset allocation and portfolio balancing can help mitigate this risk over the long term.

  • Liquidity concerns: Compared to their large-cap counterparts, small cap stocks offer lower liquidity, which might complicate the selling process.

  • Investment effort: Identifying promising small cap stocks requires considerable research and market evaluation.

  • High risk: small cap stocks, despite their high return potential, carry substantial risk.

Therefore, they might not be the best fit for conservative investors or those with a low-risk appetite. Always remember that the potential for higher returns comes with a greater risk component.

Investing in small cap stocks is an adventure. It demands patience, research, and a healthy appetite for risk. But for those who master the game, the rewards can be well worth the effort. So, are you ready to explore the potential of small cap stocks?

Learn more about the trending Wright Smallcaps Portfolio . Be sure to check out the next article in this series: 9 Essential Elements for Evaluating Small Cap Stocks

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