All you need to know about small-cap stocks

You may have come across the term ‘small-cap stocks’ while researching the stock market. But what does this term mean? 

For the sake of convenience and utility, market participants divide publicly traded companies into three broad categories – small-cap stocks, mid-cap stocks, and large-cap stocks. Small-cap stocks are those stocks that have the lowest market capitalisation among listed companies. Although small-cap stocks are present in several industries, they tend to share some common characteristics.

What are small-cap stocks? 

As highlighted above, small-cap stocks are public companies whose market value is relatively lesser when compared to mid-cap and large-cap stocks. The set threshold used to define small-cap stocks can vary since different institutions have their own interpretations of how to classify a company as a small-cap stock.  

For instance, some experts designate companies with a market cap of below Rs 5,000 crore as small-cap stocks. On the other hand, the Association of Mutual Funds in India, a self-regulatory organisation, considers all companies beyond the 250th largest company on the stock market as small-cap stocks. As a side note, all mutual fund managers use this categorisation to comply with regulatory requirements. 

To assign a category to a stock, you need to calculate the company’s market capitalisation. The calculation is simple – multiply the current share price of the company by the total number of outstanding shares in the market. For example, if the shares of a company trade at Rs 10 per share and there are 10 lakh outstanding shares, the market cap is Rs 10 x 10,00,000 = Rs 1,00,00,000 or Rs 1 crore. 

Adding to the abovementioned definition, small-cap companies are usually those that are in their nascent stage of development. Hence, their businesses might not be as established as some older companies in the market. They might also lack a stable revenue source and could require a constant influx of capital to meet business requirements. 

Here are some common features of small-cap stocks:

Associated risks:

Small-cap stocks are relatively riskier to invest in when compared to their larger counterparts. They might be among the first to be affected by external factors such as broader market downturns or troubling economic data. 

Expected returns:

Although small-cap stocks can be relatively risky, the rewards can sometimes be better than other assets. If you can identify a healthy business in its early days, its stock has the potential to deliver good returns like in the case of a midcap or large-cap stock.   

Volatility:

The price of small-cap stocks can sway by a large amount in a single day. So they are relatively more volatile. For instance, a large buy order can move the price of a small-cap stock up even in double digits while a large sell order can similarly push it lower significantly.  

Liquidity:

Small-cap stocks often have lower liquidity when compared to their larger counterparts. This means that it could be difficult for investors to acquire a large number of shares without triggering a movement in share prices. Sometimes, even when an investor is ready to pay a higher price, shares may not be readily available due to circuit limits. Circuit limits are safeguards set by an exchange to prevent large movements in stock prices. When a stock’s price hits the upper or lower circuit limit, trade orders are not fulfilled and remain pending until the circuit price restrictions are lifted by the exchange. Meanwhile, orders placed outside the circuit limit are instantly rejected.

Who should invest in small-cap stocks? 

There are many reasons why you can consider investing in small-cap stocks. But you should be aware of the risks. One wrong bet and you can lose a sizeable percentage of your capital. Typically, small-cap stocks are not ideal if you are a conservative investor and prefer to use your capital toward safer investments.  

Many large-cap and mid-cap stocks have established their popularity among investors. Thus, their growth potential could be limited over a shorter timeframe. On the other hand, the market consisting of small-cap stocks has several hidden gems that could deliver good returns.

As long as you can avoid the pitfalls associated with risky investments, small-cap stocks sometimes have the potential to deliver good returns. The small-cap stock market is also a space where you can find undervalued stocks, which can be purchased at discounted prices. 

FAQs 

Q. Are small-cap stocks the same as penny stocks? 

No. Small caps are stocks that have small market capitalisation, typically between Rs 250 crore and Rs 5,000 crore. These stocks that are traded on major stock exchanges have a greater potential for growth even though they carry some risks.

Penny stocks, on the other hand, trade at very low prices. They are often priced below Rs 10 and have much smaller market capitalisation. They are more commonly traded over the counter (OTC) or on regional exchanges than on major exchanges. Penny stocks are considered highly speculative, and their low liquidity and regulation make them riskier than small caps.

Q. How can you invest in small-cap stocks? 

The process of investing in small-cap stocks is the same as investing in any other stock. You need to have a trading account and a demat account. After logging into your trading account, you can buy small-cap stocks. 

Q. How can you identify some good small-cap stocks? 

Irrespective of what kind of stocks you want to invest in, it is always wise to identify companies that have historically shown a healthy growth rate, have credible management, and have a reasonably good outlook with visible growth opportunities in the foreseeable future.