Small-cap stocks are those whose Market capitalization is less than 5000 crores. Medium-cap and large Cap companies have higher market Capitalisation respectively. Now, consider the following facts.
1. The typical relationship between Amazon, Netflix, Google, Microsoft, and our homegrown company Infosys and TCS. They all are Technology companies, substantial and among the top companies in the World, and foremost of all they began as small companies.
2. A large company would grow but its growth potential is limited and it just can not grow over the economy of that country and of the world at any time. A small-cap company has all the time and potential to grow into a Large Cap company. This gives a small-cap company a long period of high and stupendous growth.
3. Being small and a new company, they do not have much track record. Owing to this(being new), their credential in the market is not established. Further being small their Capital float is significantly less. Institutional Investors such as Insurance Companies, Banking, and Financial Institutions, FII, and other Institutional Institutions who have a large float of money to invest in do not invest in them because their float is too less vis-a-vis the investable float required by them. This phenomenon results in poor liquidity in small-cap space. The illiquidity in these stocks is also resultant of a lack of credentials in the marketplace/being new in the marketplace
The above-narrated facts give rise to the pros and cons of investing in small-cap stocks. Let us discuss the Pros of investing in small-cap stocks.
1. Stukpendous Growth potential:- Most large-cap companies at some point in time were small or tiny companies. It is not that all companies grow to become Large companies. The journey to becoming a large cap company from a small cap is not smooth. The small companies that overgrow into Large Companies need to have some particular characteristics. The small company should have a niche product or have some sort of monopoly in production/ manufacturing/services and should have a dominant position in its market share. This donates that the company is able to meet the specific need of society in the Industry. /such companies with good management are able to give a continuous period of growth and gradually rise to become a growth company. Further, being small they are more agile and nimble and are better able to adapt to the changing environment. They are more focused on their endeavor. These characteristics of uniqueness in their business proposition, good management, agility and nimbleness, and focus give them a continuous period of growth and gradually they rise to a higher pedestal.
It's a general observation that small companies as a whole give better growth than Large Cap companies because of less overhead and lesser cost structure. Further, being small they are more agile and nimble in the changing environment and also in cost cutting. They are more focused and quickly develop an internal restructuring to the impending challenges if any.
2. Lesser competition in the Small Cap space:- Small Cap companies being small and new in the market (Formative stage) don't have a track record of performance for the general investor to see and take note of. Further being small, they have a minimal amount of Capital spread which is not enough for institutional investors such as Banks, Insurance Companies, and Foreign portfolio Investors as they have a very large amount of investible capital to invest. So, they do not look into the small-cap spaces. Because of these factors, the competition for small-cap stocks is generally subdued and primarily individual investors and small-cap funds do invest in them. Therefore, the subdued competition for small-cap stocks often lets to subdued prices for most scrips unless they get tracked for their performances. Therefore, the lesser competition gives investing people a chance to identify good stocks at a very nominal price vis-a-vis their potential to grow and multiply.
Further, it is observed that the majority of the investor community has a first preference for investing in safe and reliable large Cap space stocks, which are safe and give them growth and are less turbulent. Owing to all these factors we observe that the investible amount in small-cap companies is too less resultantly prices of these stocks remain subdued.
3. Get a winner at very low prices:- As foretold most large-cap companies especially tech companies of the day were once very small-cap companies. It is further observed that there is low investor interest in small-cap companies.on account of this lower investor interest, the prices of most small-cap companies remain subdued. One can get the Gem of a stock at a very nominal rate but the need is to identify these stars.
These characteristics of small-cap companies of having small capital, size, poor or no track record give rise to the cons of small-cap companies which are detailed as under:
Volatility:- Small Cap stocks are very much volatile. Any stress in the market and the first victim is the small-cap stock. Large-cap stocks are considered much safer, more dependable, and less volatile. If any adverse situation develops in the economy, investors sell the small-cap stocks first. The prime reason for the volatility is the nonavailability of a track record because they are in their infantile stage of growth and have a low amount of capital. All these factors do not give the investors the requisite confidence to remain invested in small-cap stocks. So, in case of upheaval in the Capital market, these companies are the first ones to be relinquished by the investors to take shelter in large-cap companies or to sit aside with the cash.
Low liquidity:-As told above that these companies have a very small track record of performance and a small capital base. Due to this, we may not get enough people to buy these stocks even at reduced or distressing rates. Because during the distressed period everyone would be selling small-cap stocks which are considered more volatile and buying large-cap stocks which are considered large-cap stocks. This situation of more supply and less demand makes the small-cap stock illiquid.
Less dividend-paying stocks:- These stocks being in the infantile state of their growth do not have enough funds to distribute to their shareholders rather they would reinvest in the business as working capital or invest in machinery etc. to enhance the productivity of their operations.
Poor fundraising capacity:-As foretold that these companies are new in the business they do not have a longer track record of performance. This absence of a good track record does not give the investor community the requisite confidence to invest in these stocks. This primarily is responsible for their poor fundraising capacity.
Having said the pitfalls and advantages of investing in small-cap stocks, it needs to be remembered that most large-cap stocks of date were once small-cap stocks. During their long journey from small-cap stocks to large-cap stocks, they traverse a long path in a comparatively shorter period giving their investors a long and stupendous period of growth for the time period. Only companies with good management, having niche products fulfilling the needs and aspirations of society or the industry, or companies producing a better product at a lower cost of production and the companies need to keep on evolving with the times with suitable seasonal inputs. We need to look for such companies while choosing a small cap for future growth.
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