Small-cap stocks: Should you include them in your portfolio for considerable gains?

Markets for equity offer a wide range of opportunities across industries and market caps. Each business, regardless of size, has its own set of risks and opportunities for expansion. It is typically difficult to attain the exponential growth that investors experience in the first few years with large cap firms because they have typically gained market traction and emerged as market leaders.

Small and mid-cap companies are the ones that are now expanding and looking for new approaches to seize markets and develop new products. Investors who want to generate significant returns must take a risk in the small and mid-cap space. Let's try to comprehend why the small-cap space is lucrative:

Firstly, small cap companies are usually in their growth phase and tend to grow at a rapid pace. The multiplier effect on their financials and market cap is huge as compared to large cap companies, which are in matured phase which tend to grow in line with the nominal GDP.

Secondly, merger and acquisition activity offers small-cap investors further opportunity. Small-cap companies are sometimes acquired by larger businesses, which presents an additional possibility. Big firms can enter new markets or obtain intellectual property by acquiring smaller enterprises.

Acquisition-minded businesses frequently pay a premium price to acquire growth companies, which generates profits as soon as a deal is disclosed. Particularly if they are currently trading below book value, small businesses that are undervalued may potentially make attractive purchase targets.

Apart from acquisition where the price discovery happens, small cap companies are also under research. This gives an additional opportunity to capture the growth phase at an early stage as institutional investors usually refrain from investing in small cap companies.

Even though these businesses have excellent development potential, investing in small caps carries a higher risk. During the down trend, the small cap companies do not have the wherewithal to face the risk. Any negative developments in the macro-economic situation hurts the small companies the most.

These events lead to a lot of volatility in their market price and therefore point of entry into such stocks is very crucial for generating gains. Small cap companies have high beta and accordingly their price movements are sharp as compared to the broader benchmarks.

We always recommend clients to diversify their portfolios across market caps to maintain a balance between risk and reward. While large cap stocks do contribute some stability, mid- and small-cap equities are where the so-called "alpha generation" comes from.

Mr. Raghvendra Nath, Managing Director of Ladderup Wealth Management