What are Small Cap Stocks?

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The companies listed in the stock market are divided into three broad categories based on their market capitalization. The market cap of a company is calculated by multiplying the current stock price of the share with the total number of outstanding shares. The categorization are as follows:

  • Large cap – Market capitalization above Rs. 20,000 crores
  • Mid cap – Market capitalization between Rs. 20,000 crores to Rs. 5,000 crores
  • Small cap – Market cap below Rs. 5,000 crores

Small cap stocks constitute of around 95% of companies listed in the stock market. Investing in small cap stocks is a prevalent practice in the stock market as investors are always looking for stocks that have an upside potential and may turn out to be mid or large cap in the future.

Features of Small Cap Stocks

There are several features associated with small cap stocks that is critical for an investor to understand. Let us understand them in detail:

  • The market capitalization of small cap stocks is less than Rs. 5,000 crores
  • Small cap stocks are usually more volatile in nature when compared to other categories. These stocks are easily influenced by market scenarios and tend to show sizable fluctuations.
  • Small cap stock investors are those investors who look for high growth opportunities. Considering the share prices are low and have an upside potential, small cap stocks grow at a good pace, especially if the industry it belongs to is forecasted to grow. In terms of growth, they usually outperform large cap stocks. Although large cap stocks have their own advantage of bringing more stability and liquidity for an investor.
  • The risk associated with small cap stocks are higher. This is due to its dependency on the market and vulnerability in volatile market situations.
  • The return potential for small cap stocks is comparatively high. If an investor can identify the right stock, that has the potential to be a multi-bagger (stocks that provide more than 100% return on original investment), it can yield great returns.
  • Considering the price of small cap stocks can be low, you get more value for your investment. By investing a lesser amount, you can own more quantity of shares.
  • A significant advantage with small cap stocks is that it allows investors to invest for both long and short term. The nature of these stocks is such that during rising markets they grow at a pace helping you reach your goals sooner.
  • The tax implications for small cap stocks are simple to evaluate as well. It is taxed under section 80C and treated as an income. If the investments are held for less than a year, then it is taxed at 15% under short term capital gains and if it is held for more than a year with a long-term capital gain of more than Rs.1 lakh, it is taxed at 10% under long term capital gains.

Reasons to Invest in Small Cap Stocks

The broader reasons to invest in small cap stocks are listed below:

  • Higher growth potential
  • The opportunity of buying stocks with great prospect at an early stage
  • With small cap stocks you can invest less and get more quantity of stocks. This can resonate well if the stocks tend to do well in the future
  • They have a good long term investment prospect
  • Can boost your portfolio significantly if it turns out to be a multi-bagger

Advantages and Disadvantages of Small-Cap Stocks

Advantages: There are several advantages associated with small cap stocks. The growth potential discussed multiple times in this article is one of the key advantages of investing in small-cap stocks. They have a higher organic growth rate when compared to other mid and large-cap stocks. As there are a smaller number of institutional investors in small-cap stocks, it- grows at an organic pace normally. These stocks allow investors to invest early in emerging technologies and other sectors and make the most of their investments as that sector grows.

Disadvantages: The primary disadvantage of investing in small-cap stocks is that it associates itself with significant risk. Especially during bear markets, the stock prices are dented significantly. It takes time for the stock prices to recover after a prolonged bearish phase. As they are not that popular in the market, they also lack on liquidity. So, a trader may find small-cap stocks hard to deal with, owing to its lower liquidity. Identifying the right small-cap stock requires considerable effort and time. An investor must research about that specific sector, before they decide to invest in a small-cap stock. Investors may find them attractive due to its high growth potential, but they have their own share of risks that needs to be factored in before you choose to invest.

Investing in Small-Cap vs Mid-Cap vs Large-Cap companies

Small-cap, mid-cap and large-cap are just categories in which the stocks are divided based on their market capitalization. For an investor what matters are the companies in which they are investing and their growth potential for future. An investor should evaluate the fundamental and technical aspects of a stock before they choose to invest. A large-cap stock may seem overpriced; however, it may still hold great value in terms of its growth opportunities for the future. Large-cap and blue-chip stocks are already very popular among investors and are highly liquid, that attracts more traders to them. As an investor you should do your due diligence in identifying the stock’s potential in the long and short term before you choose to invest.

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