If you’ve heard about small cap stocks and are wondering what they are and how they work, we’ll talk about them in this article.

What are Small Cap Stocks?

To understand small-caps, we need to first understand what “cap” stands for. Market Capitalization is a simple metric to measure the size of a company. Simply put, the value of all the company’s outstanding shares is its market capitalization.

[Market Capitalization = Total number of outstanding shares of the company x Current share price]

Now, in India, companies that have a market capitalization of less than ₹5,000 crore are called small-cap companies. In the US, small caps are categorised as companies with market cap between $300 million to $2 billion.

These small-cap companies are smaller in size, operations and revenues but they are not necessarily startups or new firms. Often, these could be old mature companies with great business models.

Here is a list of the best BSE small cap stocks. 

What are the Features of Small Cap Stocks?

1. Growth Potential: Because these companies are focusing on growth and might yet be to tap their entire addressable market or build the efficiency they targeted, they have significant growth potential. During market upswings, a fundamentally strong small cap stock might give better returns as compared to a large cap.
2. Liquidity: The volumes traded for small cap stocks are significantly lower than large caps. This is because the outstanding shares in circulation are lower than those of large caps. At times, it can get difficult to exit an investment due to low liquidity.
3. Risk: Due to the high volatility and a lower confidence in these businesses, weathering business cycles and challenges becomes riskier for these companies. The risk of investing in small caps is therefore also high. An extended recession could probably take a small cap company to bankruptcy or put it in a situation where it is being bought out by a larger company.

Direct stocks investments need active management of money which many today do not have the luxury of. Busy lifestyles often do not allow the time or expertise to invest in stocks, do the research diligently. Enter, mutual funds. There are mutual funds that focus on small caps, called, (surprise surprise!) small cap mutual funds.

How to identify the best small cap stocks/funds to buy?

Before getting into identifying the best amongst the lot, let’s spend some time in understanding the small cap equity fund definition. Simply put these are funds which comprise of small cap stocks we discussed above. These are generally managed funds which charge a fee for active management. 

This benchmark, groups together selected small cap stocks to measure and understand the market movement. Benchmark index is useful to compare performance of a portfolio against the larger market; generally the portfolio should outperform the benchmark. 

There are quite a few small cap indexes in India to pick from:

• Nifty Small Cap 100 Index
• BSE Small Cap Index
• BSE Small Cap 250 Index
• BSE Small Cap Select Index

and more. 

The BSE Small Cap Index is the best benchmark among these to measure the performance of small cap stocks since it represents a broader group of companies and is therefore a better indicator. The BSE Small Cap Index hosts 898 companies versus 250 companies in BSE Small Cap 250 Index. This benchmark has also posed a higher hurdle for fund managers to beat.

The best measure of a good small cap equity fund is its performance against the BSE Small Cap Index benchmark. The best small cap mutual funds to invest in is the one that beats the benchmark significantly. 

Want to know how to invest in small cap stocks without researching companies and with well-rounded risk mitigation? Buying the index is a great way for investors to invest in the small cap basket and achieve a diversified portfolio within the small cap space. This could be a good alternative to researching the best small cap stocks to invest in or checking for the best performing small cap stocks.

Criteria to identify the best small cap stocks to buy: 

1. Sound balance sheet
2. Positive cash flows for the last 5 years
3. Debt to Equity higher than at least 2.5
4. ROE > 20%
5. Capable management
6. Companies with economic moat
7. In sectors with high entry barriers

Criteria to identify the best small mid cap mutual funds:

1. Lower Expense ratio 
2. Outperforms the BSE Small Cap Index
3. Experience of the fund manager to navigate the market 
4. Portfolio composition and weightage
5. Direct/Regular plan to further reduce commissions 

BSE Small Cap Index Performance

Despite the weak global cues, inflation pressure predominantly in the west, India has seen growth in demand and the overall markets are well on the recovery path. Recently, the BSE Small Cap Index has outperformed the Sensex. The outperformance was mainly driven by attractive valuations after corrections earlier this year and better than expected results for Q1 2022. Prices of commodities (grains, oil etc) are also stabilising at acceptable levels which reduces the pressure on these companies’ balance sheets. The festive season and good monsoon is another reason for most firms to cheer. 

Historically too, the Small Cap Index has performed well. All small cap index fund performances are measured against this index’s performance. That is when the fund manager knows whether he/she is outperforming the market. The 10 year CAGR for BSE Small Cap Index has been a stunning 15.99% as against Nifty 50 CAGR of 12.10%. This means that Rs. 1 Lakh invested in this index fund in 2012 would have become around 4.4 Lakhs today!

This outperformance comes with a caveat.  Small-cap stocks tend to be high beta (more volatile) as compared to mid and large cap stocks. So in a market downturn like the recession of 2008 caused by the sub-prime crisis, the BSE small cap index eroded 79% of its high value in comparison with large caps which corrected around 58%. 

It takes less trading volume to move their prices, and it is common for a small-cap stock’s price to fluctuate more in a single trading day than those of larger companies.

At the same time, these stocks can give high returns when the economic conditions improve and the overall market sentiments are positive.