What are risks and opportunities associated with Small Caps?

Small-caps are a stock-picker’s paradise. While there are around 5000 listed companies in India, the top 100 large-cap companies account for about 63% of the total market capitalization of USD 5.5 Trillion. Small-caps and mid-caps are about USD 1 Trillion each (about 18% each) – quite large even by global standards. The investable universe of small-caps has significantly expanded. In 2020, the number of small-caps with market capitalization of more than Rs. 2000 crore was about 220 – today the number is 800, an increase of 4x. The largest small-cap used to be around Rs 7000 crore in market capitalization – today it is around Rs 30,000 crore.

If we apply filters of liquidity and quality, there are still more than 500 small-caps which are “investable” – a wide and vibrant range of stock, sectors and sub-sectors to choose.

Small-cap companies are often in the highest growth trajectory within their lifecycle after the high-risk start-up phase. In the micro-cap or small-cap stage, the focus of the companies is primarily on growth. The transition of small-caps to mid or large-caps offers the highest potential for wealth creation as they expand and evolve – the “multi-bagger”.

Moreover, in many high-growth segments the options are exclusively or predominantly in small-caps or mid-caps. For example there is no large-cap stock in the hotel sector, consumer durables segment etc.. There are only 2 large-cap chemical stocks versus 60 small-cap, 2 real estate large-cap versus 30 small-cap. There are many such sectors where there are 10x the number of choices in small-caps versus large-cap.

The P/E ratio of the small-cap index (Nifty Small Cap 250) is similar to that of the large-cap (Nifty 100) index, at around 19-20x on two-year forward earnings. However, the projected earnings growth for small-caps is higher, at 18% for the next couple of years versus 8-10% for large-caps. So, growth-adjusted valuations are not that expensive for small-caps.

Small-caps also tend to have higher promoter holding – more “skin in the game,” aligning their interests with those of investors. Many are not widely covered by analysts, presenting opportunities for early investors to discover companies before the broader market does.These factors make small-cap stocks a fertile ground for investors looking for long-term growth and wealth creation. However, investors also need to be aware and take into account the risks associated with small-caps viz. higher volatility, lower liquidity, lesser disclosures and transparency. Moreover, small-caps also are likely to be more vulnerable to economic downturns. While small-cap stocks can deliver impressive returns during bull markets, investors must carefully choose stocks and consider a long-term perspective when investing in this segment.

(Mihir Vora, Chief Investment Officer, at TRUST Mutual Fund)