What are the risks of investing in smallcap stocks

By Angel Broking | Published on 23rd June 2021 | 712

Investment in equity markets has grown leaps and bounces over the last few years and new inverters have a peculiar fancy for smallcap shares. Unfortunately, small-cap stocks do not possess very good names because of the nature of business they are in and the risk associated with them.

However, one should never forget that Todays’ bluechip or the large cap company was once a smallcap. Thus, smallcap companies do have a potential of exponential growth and spectacular return over the years. However, smallcap investment is not a cakewalk and everyone’s cup of tea.

Despite a heavy quantity of smallcaps available, this segment, in particular, lacks in quality, which shall be the utmost demand of the investors. Thus, the concerns of investors are valid. But, shunning them completely is not a solution to the problem.

Key Highlights

* Smallcap shares offer high growth potential

* Smallcap Index perform better in longer run

* Smalllcap stocks are highly volatile and risky

* Suitable for investors with high risk appetite

What are smallcap stocks?

Smallcap companies can be categorised or classified on the basis of two parameters. However, the purpose of this categorisation is distinguished for investors, institutions and mutual fund houses.

According to the capital market watchdog Securities Exchange and Board of India (Sebi), the top-100 companies by average market capitalization are categorized as largecap companies and those falling at 101st to 250th position are midcap companies.

However, companies starting from 251st position and beyond, fall in the category of smallcap shares. Sebi releases the list of the companies falling into each category every six months, after which mutual funds houses need to rejig their scheme portfolios accordingly.

Another classification, which is more commonly used by the investors directly buying stocks. Smallcap companies are those that have a market capitalisation of less than Rs 5,000 crore. Over 95% of Indian companies fall into this category, which makes it more difficult for the investor to pick the best names.

Smallcap companies might have a long history of underperformance but when an economy is emerging out of a recession, small-cap stocks often prove to be outperformers. Investors seeking higher returns from their investment in longer duration buy positions in such counters. Such investors have a high risk appetite.

Performance

In the last one year, till June 1, 2020, BSE Smallcap Index has gained over 115%, while BSE Midcap Index has rallied 83%, BSE 100 Index has surged 58% and BSE Sensex has soared 54%.

In the last one year, three companies have soared between 1,000-1,200%. It includes names like Tanla Platforms, Adani Total Gas and Intellect Design Arena. Apart from them, 15 other smallcap companies  like Subex, Magma Fincorp, Greenpanel Industries, Saregama India and Prince Pipes have delivered more than 500% return to the investors.

However, the performance of smallcap index does not remain hunky dory during. Like other segments of equity, they also witness rough patches, when the fall is prolonged and steep.

During the cold streak of 2018 and 2019, a dozen of companies declined over 90%, eroding investor’s wealth severely. This list is a follows:

Reliance Communication (97.6%)

Reliance Capital (97.45%)

Reliance Infra (94.7%)

PC Jewellers (94.66%)

Simplex Infrastructure (94.4%)

Jain Irrigation (93.67%)

Reliance Power (93.05%)

Jaiprakash Associates (92.46%)

SREI Infra Finance (92.06%)

Arvind (90.08%)

HSIL (90.35%)

Vakrangee (90.03%)

Between January 2018 and January 2020, the BSE Smallcap Index declined 30%, compared to a 16.5% fall in the BSE Midcap index. However, the BSE 100 Index climbed 13% and the BSE Sensex gained 25% during these two years. Due to this, BSE Smallcap Index has underperformed the largest peers since January 1, 2018 till June 1, 2021.

Keynote:

Much of the bad publicity for small companies comes from penny stocks. Investors can avoid most of those issues by investing in small companies with higher share prices. Penny stocks are also known as ‘Bhangar Stocks’ having a value less than Rs 10 and market cap of such companies is not very high.

Features of smallcap stocks

For investors, who are keen to learn investing in smallcap share, much understand the following features of such counters:

  1. Volatility: Smallcap counters are highly volatile as the influence of market phenomenons, news and fluctuations is much more on them. Thus, they can show a steep rise or fall in just a quick succession.
  2. Risk: Due to high volatility of smallcap stocks, they are more risky. However, more risks are usually associated with higher returns as well. Despite that, smallcap stocks remain laggard when the market is in recession and recovery takes a longer duration.
  3. Return: Smaller companies have a greater growth potential and thus, such counters turn multibagger over the years, highlighting the exponential growth possibilities over the years.
  4. Investment Horizon: Investment in smallcap companies need a greater investment horizon to yield better results. Short term horizons push them back in the preference list due to their risk. However, they can generate substantial returns in the long run.

Reasons to Invest In Small-Cap Stocks

There are three compelling reasons why an investor can consider putting their money into small-cap stocks:

* Benefiting from the growth potential of the small-cap companies.

* Availing quality stocks at lower prices owing to the inefficiencies of the market.

* Opportunity to avail small-cap shares at fair prices which are not influenced by large financial institutions.

Advantage of smallcap investments

While smallcap shares have significant returns, one shall not undermine the significant benefits and underlying value in such stocks, which many other investors often fail to realize:

Most successful large-cap companies started at one time as small businesses. Small-caps give the individual investor a chance to get in on the ground floor. These younger firms are bringing new products and services to the market or creating entirely new markets.

Everyone talks about finding the next Microsoft, Amazon, or Netflix because these companies were once small caps. Had you possessed the foresight to invest in them from the beginning, even a modest commitment would have ballooned into a small fortune. Here are some of the key benefits of investing in smallcap shares:

  1. Growth Potential: Smaller companies tend to have a better organic growth and thus, small-cap companies have a greater potential to grow and acquire capital in due time. Because small-caps are just companies with low total values, they can grow in ways that are simply impossible for large companies. Investors need to understand that Reliance Industries was once a smallcap. Even an international giant like Amazon was a small start up which started from a garage. If one has a hawk eye to catch the stock at the correct time, smallcap stocks can balloon into a multi billion or perhaps, trillion organisation and build fortunes for the investors.
  1. Fair Pricing: Usually, larger counters are over valued as both individual and institutional investors lap up such counters. Many index funds, pension funds, endowment funds invest in largecap counters, pushing their value up and making them expensive. Compared to such inflated stocks, many smallcap counters are available at a hefty discount, but one must study the company before making a call.
  2. Quality at low prices: Many smaller companies are under-recognised. Not many investors are aware of them and their business. This makes such companies trade at underpriced valuations. However, with little research and correct advice, investors can acquire such ‘diamonds’ at very lower rates.

The Bottom line

The primary advantage of investing in individual small-cap stocks is the significant upside growth potential that is unmatched by larger companies. Value in smallcaps is a way to boost returns for investors. Also, merger and acquisition activity provides another opportunity for small-cap investors.

Acquisitive companies usually pay a premium to acquire growth firms, leading to profits as soon as a deal is announced publicly. Undervalued small companies can also make tempting takeover targets, especially when they are selling for below book value.

However, investors must not forget that every investment has its own risk, and smallcaps are sitting at the higher end of the table. Additionally, investors should take into account their risk appetite before investing and allocate their investments accordingly.

However, if individuals are not very well-versed with their market knowledge, they always have the option to seek professional assistance.