What Lies Ahead for Small Caps?

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Small cap companies have always held a certain fascination for investors. By virtue of their higher growth potential, they can at times generate outstanding returns...or so the story goes. So, how well have the smaller companies fared during the past one year?

Well, they have outpaced large caps and midcaps. As per an article in the Economic Times, small caps set off the fireworks during Samvat 2072. 34 companies which form part of the S&P BSE Small Cap index more than doubled investor wealth since last Diwali. Furthermore, there were many small cap stocks that rose more than 100% during the same period. Some of the names include Pricol, Borosil, Orient Paper, Gujarat Narmada, and Atlanta.

So far so good. The question, however, comes as what lies ahead for small caps?

The recent run up in the price of small cap stocks has made investors susceptible to a correction. There are also some other concerns such as the rising debt levels.

Debt levels of small cap companies has risen above the long term average during the recent years. With an average debt to equity of 1x, this number has touched as high as 1.2x in recent years. The higher debt along with the fall in profitability has meant that interest coverage ratios too have suffered drastically. From upwards of 4.5 times in FY07, this is now down to a disquieting 1.1 times in FY16.

Lastly, we have the ongoing global economic volatility that can weigh on small caps. One shall note that small caps are much less resilient than the larger peers to an adverse macroeconomic cycle. They can be quite shaky during an extended patch of cyclical downturn.

So while small caps have great return potential, they are also fraught with high risks at this juncture. But does that mean one shall avoid all small cap companies? Here's our in-house small cap expert Richa Agarwal:

• It's true that small caps are a risky asset class. That said, many individual small caps are too small to have any significant impact of macro factors. So for small caps, the business potential and risks rather arise from very specific risk factors - management quality for example - which can be mitigated with diligent research and diversification.
  
  In an economy on the cusp of recovery, some small-cap businesses are poised to grow at better rates than their larger counterparts. Value investing with a bottom-up focus could give your portfolio a great boost over the long term.

So there are enough opportunities in the small cap space. Do check out our report, Steady Income Small Caps - III (subscription required), to know more about these opportunities.

Lastly, the choice is not between small caps or large caps. Smart investing means having a healthy mix of asset classes. And if you are seeking higher returns over three to five years, completely ignoring the small cap space may not be such a good idea.

For information on how to pick stocks that have the potential to deliver big returns, download our special report now!

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