Pros and Cons of Investing in Small-Cap Stocks

The last few years have seen a drastic shift in the Indian investor mindset as the equity markets are starting to see more participation from retail investors than ever before. There has also been a noticeable attraction towards small-cap stocks, as investors are ready to take on higher risks for better profits. Small-cap stocks, however, still continue to ring the risk signal because of the possibility of losses and lack of information or knowledge about the company apart from the non-availability of historical trends.

However, every investor must remember that the stocks that are large-cap today would once have been small caps. Thus, small-cap stocks offer the potential for significant growth and substantial return in the long run. However, small-cap investments are not smooth sailing and these do not fit into every investor’s risk appetite.

So, should investors invest in small-cap stocks? Are they worth the risk? Here, we will highlight some of the pros and cons of investing in small-cap stocks to aid investors with better investment decision-making.

What are small-cap stocks?

Small-cap stocks are those stocks ranked from 251st and beyond in terms of market capitalisation. Market capitalization is a company’s total outstanding shares multiplied by the current share price. Some of the features of small-cap companies are:

• These are smaller in size,
• Such companies are generally into certain niche businesses,
• Small-cap companies may have substantial growth potential,
• Stocks of such companies can become multi-baggers in the future, and
• There is always a high risk-return trade-off involved while investing in small-cap companies.

What are the benefits and disadvantages of small-cap stock investments?

Many investors include small-cap stocks within their portfolios to gain balance from the overall risk and return perspective. Before investing in small-cap stocks, it is important for investors to know about the below-mentioned pros and cons:

Advantages of small-cap investments

Some small-cap stocks can offer significant returns. This is because of the underlying value and benefits of investing in such stocks. Investors must therefore take note of the below-mentioned advantages that these can offer:

1. Growth opportunity

Small-sized companies generally have better chances of achieving organic growth. Therefore, such companies can acquire capital for achieving as per planned timelines. Since these companies have relatively lower net values, they can grow in directions that are not possible for large companies to explore. Companies that are giants today were once small start-ups, for example, Facebook. In the stock markets, to identify the right small-cap stock that can grow into a billion-dollar company, one must have a deeper understanding of company fundamentals. 

2. Lower pricing

Generally, due to high demand, larger companies may be over-valued since individuals, institutional investors, etc., invest in them and thereby push the stock value up. In contrast, many small-cap stocks are easily available at substantial discounts. This makes it easier for retail investors to invest in them using limited funds. However, an investor must carefully study the company before investing in the stock.

3. Quality

Small-cap stocks often go unrecognised since not many investors are aware of these companies and the businesses that they are into. Therefore, such stocks tend to be underpriced and underrated. Investors can conduct some amount of research on such stocks before buying them at lower rates and potentially fetching profits in the future.

Disadvantages of small-cap investments

Despite a range of opportunities that investors can explore through small-cap investments, many of these may lack quality. Here are some of the disadvantages of small-cap stocks that investors should bear in mind before investing in them:

1. Higher risk

Most stock market investors would know that small-cap stocks often pose higher risks as compared to large-cap stocks. It is the growth potential of such companies that dictates their valuation. Investors must therefore note that not all small-cap companies can turn profitable and succeed in becoming large-cap stocks.

2. Higher volatility

Small-cap stocks often see higher trading volatility due to their size. This is because such stocks are traded in lower volumes, resulting in constant price movements. 

Did you know

A small-cap stock may swing around 5% or more within a given trading day. Not much in-depth or regularly updated information can be found on such stocks since very few analysts cover them. Identifying the potential of a small-cap stock may therefore depend heavily on an investor’s knowledge and research.

Young companies often introduce new products and services to a stagnant market and end up creating new markets for themselves. Today, everyone knows about the growth of Microsoft, Amazon, Facebook, etc. These were once small caps and investors who possessed the know-how of identifying such gems have seen their modest wealth balloon into larger fortunes.

Conclusion

If one looks at it positively, small-cap stocks offer growth opportunities that large-cap stocks cannot. This, combined with a low-cost investment, can generate high long-term returns if these companies do well. On the flip-side, however, small-cap stock prices are often volatile and therefore not suitable for investors with short-term or medium-term investment horizons. Lower liquidity and higher risk indicate that investors should spend more time researching these stocks.

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