Compare the benefits and risks of investing in small-cap and large-cap stocks.
Thursday, Aug 15, 2024
We've been familiarizing ourselves with the larger caps because of the big name they have, which translates to them being stable and possibly churning out better profits. Is it the ultimate truth, doesn't the small cap add to any benefit?
You might probably be starting to gather a couple of stocks in your portfolio. Might have even questioned the percentage by which the exposure to the small and large cap stocks be.
That's technically a good question to be asking.
You can also pick a Smallcase investment to save yourself from the intricacies of constructing a good portfolio.
It's curated by the experts, who have answers to everything they create for you in the portfolio, which is why it can be an easy choice.
Let's find out what it means to have small and large cap stocks in the portfolio.
What's a small cap and large cap stock?
First and foremost, the term cap refers to capitalization, which is the overall value of the outstanding shares that a company has.
Typically, if the valuation is anywhere between $300 million and $2 billion, the company falls under – small cap category.
If the valuation is above $10 billion or more, the company falls under – large cap
What makes small caps appealing?
Here's the key thing to look at each of them.
1. The growth potential
These companies are on their growth trajectory and they have a lot of room to grow, unlike the big stable players. You can take the example of Amazon, which started off as a small cap company in the 1990s and is now among the world's longest companies.
The big market capitalisation always starts with the small cap. If you are a long term investor, you always know the best company in the small cap at some point in time can get there.
Basically, large cap companies saturate their primary market, so there is slow growth and small cap companies are mostly in niche markets that have room for expansion.
The catch here is to identify these potentially successful companies earlier.
2. It's a gem that's undiscovered
Mostly when the eyes are on the large cap, who's actually seeing the small caps? The majority prefer to keep an keep an eye on large caps and the analysts run behind where the investor's interest lies. There are hardly any analysts who care about small cap stocks.
The lack of extensive coverage of these stocks causes information inefficiency and that’s reflected in the stock price.
As a result, it's mispriced, which is either overvalued or undervalued when compared to its true worth. Investors go behind undervalued stocks for price appreciation and only those who understand the true worth of the company believe they should hold on to it, which others have overlooked.
Nevertheless, Amazon's stock once traded below $10 per share in the early 2000s, and investors who held onto their shares have seen tremendous growth in value over the years.
3. They are the targets for acquisition
To tap into newer markets, it's always easier for larger companies to acquire smaller companies to boost their growth.
As a matter of fact, they are more manageable to acquire than the larger companies. In this case, they offer to buy shares at a higher price than the market value, which is a premium offered to the shareholders to incentivise them to sell their stakes.
As an example, Eveready Industries saw a controlling stake acquired by the Burman family, the promoter of Dabur India. Reports indicate that the stock price of Eveready Industries rose from around 300 to approximately 440 rupees following news of this development.
This would happen when small cap companies are at the forefront of new technology or business models. If the small cap company has a stronger position in the market that a large cap company wants to enter, why would that be? It's easier to acquire than to build it entirely from scratch.
It doesn't mean all companies get acquired, it is only a case in a select few and sometimes it even falls through, which affects the stock price of the small cap companies.
It's always good to keep track of fundamental strength alongside acquisition targets and not on acquisition targets alone.
Small caps come with risk, you might need to invest in them in the short term to lower your risk exposure, might have to keep the asset allocation lower in small caps depending on your goals and risk profile. Also, finding one charming company isn't a simple task as we don't have enough information on the small cap companies like that in large cap companies.
You can rather prefer investing in the best Smallcase that has its research sorted out, allowing you to invest in this segment correctly.
One such Smallcase investment option is here Smallcap Compounders.
What about the large cap companies?
The things that give the edge to large caps.
1. Stability, which is strength,.
Large cap companies have a history of persistently running their operations for a long time and that's in fact the important aspect that makes investors safely rely on them.
Even the dominant position in the market makes it more obvious to boost the investor's confidence. For them to keep running, they need strong financial resources, broader revenue streams, and, most importantly, greater brand recognition.
For instance, Microsoft enterprise software is integrated into every corporate’s systems worldwide, without any doubt.
They have surplus reserves to bear any downturn in the market, they can quickly adapt to changes and they can invest more in R&D than the small cap companies. Also can attract any top talent.
It has volatility but less compared to the small cap companies that make a space low risk profiles and who want to take predictable income.
2. They attract investors with dividends
They make stable cash flows, even exceeding the reinvestment needed to give the investors dividends. What does it signify, though?
It's not just buying dividends but also knowing that the companies they invested in are financially sound and their management is well equipped.
The large cap companies are proud of their dividend track record and even come under the title Dividend Aristocrats, as they have been increasing dividends consistently for 25+ years consecutively.
From an investor's point of view, in a low growth environment, the stock price may not increase rapidly and the dividends can serve as a benefit to their overall profit.
Again, when prices fall during the downturn, the dividends can still act as a cushion for their portfolio regardless.
Also, not only do large cap companies provide dividends, in fact, there are also small cap companies offering dividends.
Here's a Smallcase investment with an 80% allocation in small cap companies that are giving dividends.
3. They are more liquid to buy and sell whenever
If you can buy a stock easily, it must also be easy to sell when you wish to, and in cases where it's not, you may have to sell it at a price you don't wish to, resulting in increasing or reducing your loss of profits.
This isn't a problem at all in large cap companies, as they are highly liquid as their trading volume and outstanding shares are so high that you have buyers and sellers in abundance to even trade in larger quantities. But it's a concern in small caps as they may not be highly liquid.
It's beneficial to the institutional investors who are managing the larger portfolio to make trades without moving the market. On the other hand, individual investors can easily adjust their position at any time.
Large caps seem most comfortable to you? Then one of the best Smallcase we have for you is Emerging Global Giants.
You can find the smartest Smallcase investment as well and we call it Smart Index Advantage
Talking of the risk in small cap and large cap stocks
The risk is there in any investments, but let's go specifically into it.
1. Volatility
During the global financial crisis, small-cap stocks, as represented by indices like the Nifty smallcap 100, experienced significantly steeper declines compared to large-cap stocks, represented by the Nifty 50. The small-cap index fell considerably more than the Nifty 50, illustrating the higher volatility and risk associated with smaller companies during major market downturns
2. Economic Sensitivity
Economic downturns are something that affects small caps. During the market crash triggered by the COVID-19 pandemic in early 2020, the Nifty Smallcap 100 index experienced a significantly sharper decline compared to the Nifty 50 index. From January to March of that year, small-cap stocks, as represented by the Nifty Smallcap 100, saw a much steeper fall than their large-cap counterparts in the Nifty 50. This disparity in performance once again highlighted the tendency of smaller companies to be more vulnerable to severe market downturns compared to larger, more established firms.
However, small caps have a higher tendency to recover faster during upswings.
Performance so far
Here's how the 10 years CAGR data in Nifty Smallcap 100 and Nifty 50 looks. Small caps with much volatility and over 10 years have given good returns that beat Nifty 50. From 2014 to 2024, a CAGR of 12.50% was provided by Nifty 50, whereas Nifty Smallcap 100 provided a CAGR of 18.8%. The outperformance has been consistent even in 3 year and 5 year data.
So what about your portfolio?
You know the risk involved in small cap companies, so diving into 100% of one segment is not at all the key. Of course, you need diversification, considering you are scared of taking higher risks too.
If that's the case and you need enhanced returns, include both of them in the portfolio. But again, it varies as per your risk profile. If you are a prudent investor, then don't exceed more than 30% in small cap stocks, and if you are an aggressive investor, you can increase that bracket while adjusting large caps stocks accordingly.
If that's too much work to construct your portfolio, we have you sorted with a Smallcase investment called High Quality, Right Price Smallcase. It's a combination of asset allocation in both segments picked rightly.
We don't leave you hanging around, we ensure to give you rebalancing updates every quarter, so that you are booking your profits correctly and adding other stocks to increase the returns.
Keep these things in mind:
1. If higher returns are the focus while you are willing to bear the volatility, then go ahead and increase the small cap stock allocation in your portfolio.
2. If you are a young investor with a much longer horizon of investment, then lean on small cap, while people who are about to retire can rely on large cap.
3. If you relatively have a smaller portfolio, then go towards large cap stocks, and the larger portfolio can prefer small cap stocks.
Always remember, if you are going to pick the stocks directly, to do quality research before having them in your portfolio.
If that's something complicated to look at, then you have mutual funds, ETFs, and smallcase investments, which are created by doing ample research for investors. Especially if you are a beginner, start with the Smallcase investments.
You have SIP options that help you tackle the market volatility issue with regular investments rather than lump sum investments, and that also helps you start with a smaller amount.
While all this is good, rebalancing the portfolio is something that every individual investor must do to book the profits and adjust the portfolio by adding new stocks. As we are dealing with money, we can't invest and forget.
Wrapping up
We invest with the purpose of growing money and there is no one who likes to lose it. There is risk with every investment but the level of it varies from one to another. Small Caps have a high growth potential as they are a growing company and carry a much higher risk.
Large caps are established and stable with minimal risk. It's up to you as to what you want, as it also depends on how much risk you are willing to take. The risk capacity shouldn't be random but rather consider the goal for which you are trying to build this corpus.
Just as growing a company is not a day's matter but rather years, the concept of growing your portfolio is a long term process rather than a shorter . You need to keep reviewing your strategy to ultimately get where you want.
GreenPortfolio is a SEBI registered company offering portfolio management services and smallcases for building a great portfolio. Try our smallcase investments we have the best smallcases here.
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