10 Important Facts about Indian Small-cap Stocks

Smallcap stocks are shares of companies with a total market capitalization of less than Rs 50 bn (that's 5,000 cr).

Betting on them is perceived to be risky. However, the potential for higher returns makes them an appealing investment avenue.

While there is nothing wrong with aiming for higher returns, it is necessary to understand them well. Especially, the kind of risks that tag along with the outsized returns.

Keeping this in mind, we highlight ten important facts about the best Indian smallcap stocks.

#1 The prospects of high returns

We all know the pull towards investing in smallcap stocks; the prospect of potentially life-changing returns.

Due to their relatively small size, they can grow exponentially. Sometimes, as much as 100 times. As a result, they can generate outrageous returns.

Take Infosys, for example. Back in the day, when it was a small company, it was easier for the IT major to double its sales in two years. But now, as a large established organisation, it will find it tough to do the same.

But these outsized returns aren't as smooth as you might think. They usually happen after much turbulence. This little but important fact brings us to our next point.

#2 The journey to high returns is not smooth

The massive upside potential in smallcap companies comes with high volatility. Therefore, if you are investing in smallcap stocks you will have to accept the volatility that comes with it.

However, as you are assuming that extra bit of risk, you will be compensated in the form of higher returns, provided you have invested in a fundamentally strong smallcap stock.

While you may earn a 15% return in a stable large-cap stock like Asian Paints, you could earn up to 25-30% return in a volatile smallcap.

In the long run, it will be worth it. Because apart from higher returns, smallcap stocks are also the gateway to niche growth stories.

#3 Want to invest in a market leader that makes the mattresses you sleep in? Or a specialty chemical player that vulcanizes rubber? You got it!

Now, some industries and companies operate in tiny or niche spaces. This means that they never really become big.

However, that does not mean they are not exciting businesses. Moreover, such stocks also offer a better mix of themes for your portfolio holdings.

Take Oriental Carbon & Chemicals, for instance.

The company is a market leader that enjoys 60% market share in the specialty chemical business. It is one of the few manufacturers of a rare chemical, insoluble sulphur, which vulcanizes rubber for manufacturing tyres.

Even Mayur Uniquoters, a market leader that manufactures synthetic leather, is a great example.

These are not recommendations but examples of high potential smallcaps.

But these niche stories and new businesses take time to realise their full potential. This brings us to our next point of discussion.

#4 Smallcap stocks can sometimes test your patience.

Smallcap stocks are relatively new businesses in the early stages of the business cycle. Sometimes these businesses take time to realise their full potential. Much like a good investment strategy usually takes time to play out.

Unfortunately, no one can predict that timeline for you, which makes it even more challenging.

Think about it. What if Rakesh Jhunjhunwala had sold Titan after three years of investing in it? He bought it in 2002 at around Rs 2 per share and the stock didn't perform until 2005. Now, the stock trades at Rs 2,500, up 1,200 times in 20 years, outperforming the likes of TCS and Infosys.

So, apart from keeping calm what does this tell us?

It tells us that you must only invest your surplus funds in smallcap stocks. Money that you will not need in the short term.

However, smallcap stocks can outperform the best companies in a bull market. They can generate outsized returns in a short period.

Take Tata Elxsi, for instance. The company was listed at Rs 35 per share way back in 1999. It turned a ten-bagger after 14 long years of listing. But when it did, it went up from Rs 800 to Rs 8,000 in a short span of two and a half years.

But how is it that they outperform their larger counterparts in bull markets?

Let's find out.

#5 You can multiply your money faster with smallcaps in bull markets

A cursory glance at history tells us that smallcap stocks have outperformed largecaps in bull markets.

But what makes them tick in a bull market?

Small companies are a lot more agile and have more room to grow than large corporations. So, if these businesses can grab great opportunities, they can get on the fast track to growth.

Eventually, if the business does well, a smallcap can quickly grow into a midcap or largecap. Some of the big guns of today such as Bajaj Finance, Titan, Eicher Motors were smallcaps 15 years ago.

But these bull market outperformers are at high risk during market meltdowns.

Let's understand this better.

#6 You may lose money faster with a smallcap in bear markets

Smallcap stocks are at risk during market downturns. This phenomenon was very evident in the early months of the pandemic.

During the first few months, smallcap stocks underperformed their largecap peers by a significant margin.

Now, this is all thanks to basic human nature. When faced with any uncertainty, you want to be safe with your money.

You don't want it floundering around in new businesses. They don't have the same resources as large corporations with a long history of operations. Moreover, you want to be able to liquidate your holdings faster.

Therefore, during any economic crisis, investors dump their smaller highly volatile stocks first, i.e. smallcaps. They flock over to well-established and liquid companies, i.e. largecaps.

But why does this happen?

Let's find out.

#7 You might find them difficult to trade in, i.e. less liquid

Sometimes, smaller companies may not seem attractive to regular traders and speculators. But that doesn't make them any less interesting, just difficult to trade in.

But how does that affect you?

Not only does it make the stock more volatile, but it also prohibits you from buying or selling the stock at your desired price.

Moreover, trading in less liquid stocks can increase the cost of transactions, as such investments usually carry higher fixed costs.

However, less liquid stocks can also make for great investments. Some of the most unattractive, dormant stocks have gone on to become the top multi-baggers of today.

Rajratan Global Wire, a leading bead-wire manufacturer, up 10x in 1.5 years, was trading at the lower end of the liquidity spectrum until recently (January 2021).

The lack of liquidity should not stop you from investing in great growth stories. However, institutional buyers find this a constraint.

Let us understand this better.

#8 The big boys of the investing world, steer clear of smallcap stocks

Institutional investors are large investors, domestic and international. They are the big boys of the investing community, always on the prowl for good investments that are yet to realise their full potential.

But since they trade in large quantities, they stay away from less liquid stocks that are difficult to trade in. Therefore, smallcap stocks generally have little to no institutional investors. Especially compared to their larger counterparts.

But the absence of institutional investors also doesn't make the stock any less attractive. This can change overnight.

A classic example is the chemical company Balaji Amines. The stock didn't come into the limelight until March 2021. Until the total institutional holding jumped from 2% to 4% over the next two quarters, boosting the stock price.

The stock price of Balaji Amines went from trading at Rs 1,600 per share in January 2021 to Rs 4,000 per share in September 2021, multiplying in a few months.

So, smallcap stocks are just undiscovered growth stories operating under the radar. They carry the potential for re-rating which highlights our next important fact.

#9 smallcap stocks are like a story that hasn't been told and therefore, carry re-rating potential

Small-cap stocks are like undiscovered gold, like a Titan or Eicher Motors in the early 2000s.

Now this means they are available at a bargain price. But this also means you can be one of the first investors in the company. Much before they are discovered by the big boys of the investing community.

When these stocks hit the limelight, they are re-rated. Their valuations and prices go through the roof, as we saw in the case of Balaji Amines. The stock multiplied once the institutional investors came marching in.

However, just because smallcaps, as a category, tend to multiply faster, doesn't mean you buy into anything. You must be highly selective and choose wisely.

#10 There are plenty of rotten fish in the smallcap sea; choose wisely.

There are hundreds of mid-cap and large-cap companies listed on the stock exchanges. But the numbers for smallcaps run into a few thousand.

Some are good, while others are not.

So as an investor looking to profit from smallcaps, be careful.

Smallcap stocks usually derive value from their growth potential, not existing assets or profits. But sometimes, the growth potential doesn't come through. So, these smaller companies with shady management can cause large dents in your portfolios.

Therefore, act wisely while picking out investments in the smallcap space. Look for financial strength, economic moats in a business, leadership in the market, management skills etc.

The safer, the better.

In conclusion

Although smallcap stocks carry greater risk than the stocks of large companies, with the right stock selection skills and investing temperament, they are worth investing in.

The attractive upside potential in bull markets makes them worth the risk.

Imagine spotting the next Titan or HDFC Bank. Not only will it make up for the other losers in your portfolio, but it will also multiply your wealth beyond your imagination.

Disclaimer: This article is for information purposes only. It is not a stock recommendation and should not be treated as such. Learn more about our recommendation services here...