How to navigate the risky yet rewarding small-cap market? 4 experts share insights

Financial experts emphasize the high-risk, high-reward nature of small-cap stocks, advocating thorough research and quality assessments for potential investment.

Manik Kumar Malakar
First Published20 Dec 2023, 09:58 AM IST
Small-cap equities represent the most precarious segment of the stock market.
Small-cap equities represent the most precarious segment of the stock market.

Small-cap stocks are the riskiest part of the equity market. They have the potential to give you returns that beat the large caps; yet if they fall they have the potential to set you back by a pretty packet.

And yet there are the experts who make money, in these very same tricky waters. These very same experts give investors an idea of how experts decipher the small-cap shoals for investments.

Small-cap investments: Key considerations and quality filters

“The small-cap category demands intensive research to identify stocks and constant vigilance throughout the (investment) journey to build conviction on the thesis and the value proposition,” says Anil Ghelani, Head – Passive Investments & Products, DSP Mutual Fund.

Typically small caps have higher chances of sharp drawdowns as compared to large caps and are also relatively less liquid. Hence it is important to focus on good quality stocks within this segment.

What are the crucial factors in small-cap investments?

While there are many factors to look at, some useful quality filters would be higher Return on Equity, lower Debt to Equity and consistency of earnings growth. “Certain areas which could be considered as negative would be high pledge of promoter holdings, lower liquidity, high volatility, etc,” says Ghelani.

“The key aspects (when fund managers look to invest into small caps) include the company's financial health, growth potential, competitive positioning, management quality, and industry trends,” says Pankaj Shrestha – Head Investment Services, Prabhudas Lilladher Wealth.

“Being in the small-cap space, the companies come with their own set of risks,” says Amar Ranu, Head - Investment products & insights, Anand Rathi Shares and Stock Brokers. The biggest risk is corporate governance risk and management integrity which should be beyond compromise and non-negotiable.

Also, one should also see how the promoter has utilised the capital in the past and has not ventured into unnecessary industries which are unrelated or have no integration with the current line of business.

“The key factor to be looked into is capital allocation rather than capital selection,” says Ranu.

Embracing innovation and emerging sectors

“In case investors focus on better run small-cap companies, there are still opportunities in the space for making medium-term returns,” says Deepak Jasani, Head of Retail Research at HDFC Securities.

The fact that there are a number of companies in the small-cap space means that there is always a scope for stock picking. In emerging areas like defence, railways, electronics etc, you only have small and midcap companies, and one has to invest in them to benefit from the theme.

In the last 20 years, the world has seen many new business models being created, thanks to innovation. From products to services, one-time licences to subscription-based business models, from offline retail to e-commerce, on-site to the cloud, ICE (internal combustion) engines to electric vehicles (EVs), and so on. These shifts have been well-captured in the listed space in developed markets. However, India is yet to capture the value in these areas. These schemes are likely to benefit by investing in these companies.

“Because the next generation of innovative companies would most likely be found in the mid and small-cap space, these schemes have significantly invested in the mid and small-cap stocks,” says Jasani.

Manik Kumar Malakar is a personal finance writer.


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First Published:20 Dec 2023, 09:58 AM IST
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