What are Small Cap Stocks and How to Evaluate the Best Small Cap Stocks?

Small cap stocks are like the backbenchers in a class. The faculty has very little expectations from them. Their chances of becoming class topper are low. But not impossible. Similarly, small cap stocks are at the bottom of an investor’s buy list. They are considered to be risky bets as they belong to lesser known companies. Ideally, only highly aggressive investors should invest in small cap stocks.

While small cap stocks are volatile, they do provide wealth creation opportunities. Imagine being an early investor in United phosphorus limited (UPL) in 2004, its share price was Rs 29. Today its share price is Rs 607. UPL has generated a compounded annual growth rate (CAGR) of 21%. It is no longer a small cap stock. It is now a large-cap stock with market capitalisation of Rs 48,509 crores.

Every large cap stock we see today was once a small cap or mid cap stock. To create wealth, you need to discover such superior small cap stocks and hold them for the long term. In this article, we will learn what are small cap stocks and how to discover best small cap stocks.

So let’s begin.

What are Small Cap Stocks? – Definition of Small Cap Stocks

The Securities and Exchange Board of India (SEBI) defines small cap stocks as companies ranked beyond 251 as per market capitalisation. The market capitalisation of small cap companies is generally less than Rs 5,000 crore. Small cap stocks have the potential to deliver superior returns in the long term. But they are incredibly volatile and are riskier than large cap and mid cap stocks.

There are two main small cap indices in India. These help investors gauge the overall trend of small cap stocks.

Nifty Small Cap 50 index consists of the top 50 most traded small cap stocks in the market. Whereas S&P BSE small cap index represents the top 250 small cap stocks in the market.

List of Best Small Cap Stocks in India – 2021

Sr. No Company Name BSE Scrip Code NSE Symbol Industry Market Capitalization ( Rs in Cr)
1 Indian Energy Exchange 540750 IEX Power Generation/Distribution 7,788
2 NESCO Ltd. 505355 NESCO Services 4,234
3 Thyrocare Technologies Ltd 539871 THYROCARE Healthcare Services 4,888
4 Delta Corp Ltd 532848 DELTACORP Services 3,988
5 VST Industries 509966 VSTIND Consumer Goods 5,585
6 Sobha Ltd 532784 SOBHA Construction 4,340
7 Bajaj Consumer Care 533229 BAJAJCON FMCG 3,820
8 Heidelberg Cement 500292 HEIDELBERG Cement 5,419
9 Mishra Dhatu Nigam Ltd. 541195 MIDHANI Metals 3,541
10 JK Paper Ltd 532162 JKPAPER Paper 2,263

Characteristics of Small Cap Stocks

1. High Volatility

Small cap stocks belong to less stable companies and hence they are highly volatile. They underperform large and midcap stocks in a bear market. But small cap stocks are outperformers in a bull market.

2. High Risk

Small cap stocks belong to lesser known companies having limited cash reserves. So they are more likely to have negative cash flows during economic slowdowns. Due to this, small cap companies have a greater chance of going bankrupt during economic contractions.

3. Superior Growth Potential

Risk and returns go hand in hand. Small cap stocks are highly risky. But they also provide superior growth. For example: Delta Corp Ltd is one of the best small cap stocks in India. In March 2020, it was trading near its 52-week low at Rs 59.39. Today its stock price is Rs 152. It has generated a CAGR of 156% in the last 1 year! Such growth opportunities are not available in large-cap stocks.

4. Low liquidity

Small cap stocks are generally less liquid compared to large or midcap stocks. This is because very few investors trade in small cap stocks. However, a stock can become liquid over time with better price discovery and broader stock ownership.

Historical Performance of BSE Small cap vs Sensex

Small cap stocks

What Should You Look at Before Investing in Small Cap Stocks?

1. Financial strength of the company

 The share price of a company rises when it has a sound financial background. While analysing the financial strength of a company you must look for:

  • Decent liquidity ratios like current ratio and quick ratio.
  • The company’s cash flow should remain consistent over years.
  • Low debt on the balance sheet.

A company with strong balance sheet and stable financial ratios have high growth potential against its peers.

2. Rising sales and profits

Small cap companies have low cash reserves. They are heavily dependent on their sales. Hence, before investing in a small company you must check its sales and profit numbers for at least 5 years. Rising sales can help the company grow quickly. High profits help the company improve its income and margins through cost optimisation. A company with consistent growth can provide good returns to its investors in the long term.

3. High operating margin

Operating profit margin measures the profitability of a business.

This ratio helps us understand how much percentage of profits the company generates from its operations before paying taxes and interest. A company with consistently increasing operating profit margin can prove to be a good investment opportunity.

4. Quality of management

Small cap companies do not have much room for error. Even a small management error can spell doom for them. Hence investors should do a thorough background check of the company’s promoters and management before investing.

Check out our video on how you can identify the best small cap stocks to buy in India.

Alternatives to Investing in Small Cap Stocks

Investing in small cap stocks involves huge risk. Hence, you must include large cap and mid cap stocks to balance your overall portfolio. But selecting one or two small cap stocks from more than 250 stocks is difficult. Instead investors can invest in small cap mutual funds. They help in portfolio diversification, and are professionally managed by experts.

Small cap mutual funds invest 80% of their corpus in stocks of small cap companies. The remaining 20% is invested in large cap or midcap stocks. In the long run, small cap mutual funds have outperformed large and midcap mutual funds.

Historical returns provided by mutual funds

Small cap stocks

List of Best Small Cap Mutual Funds in India for 2021

Small cap fund 6 months 1 Year 3 Years 5 Years AUM (in Rs cr) Expense Ratio
Axis Small Cap Fund – Regular Plan Growth 35.81% 79.42% 17.29% 18.74% Rs 4,485.04 2.06%
Kotak Small Cap Fund – Growth 53.36% 125.62% 14.97% 18.73% Rs 3,423.32 2.1%
DSP Small Cap Fund – Regular Plan – Growth  35.60% 98.50% 7.61% 14.75% Rs 6,454.99 1.96%
SBI Small Cap Fund Regular Growth 41.49% 90.24% 12.14% 20.75% Rs 7,569.83 1.83%
L&T Emerging Businesses Fund Growth 43.35% 96.63% 4.04% 17.25% Rs 5,774.04 1.95%
IDBI Small Cap Fund – Regular Plan – Growth 41.93% 88.40% 5.61% Rs 112.53 2.5%
ICICI Prudential Small cap Fund – Growth 42.70% 103.93% 9.47% 14.91% Rs 1,991 2.16%

*This is simply the list of best small cap funds. This is not investment advice.

To conclude, small cap stocks are volatile in the short term. But to create wealth, you need to be patient and never let short term volatility affect you. So, invest in the best small cap stocks, by opening a FREE Demat account with Samco – India’s best equity stockbroker!

Happy investing 

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