Building sustainable wealth via small-cap investments

Creating lasting and sustainable wealth is the aspiration of every investor, and achieving this goal often involves exploring different asset classes and investment strategies. If you are also assessing investment options aimed at accumulating sustainable wealth, small-cap stocks, with their potential for substantial returns over the long haul, could be a compelling choice.

The appeal of small-caps

Before we go into the details of why small-caps can make an interesting and excellent investment choice, especially for long-term investors, let us understand what the term indicates. Small-cap stocks are companies which have a market capitalisation that is lower than their bigger peers – the large-caps and the mid-caps. Typically, small caps are stocks of a public company whose total market value or market capitalisation is between $250 million and $2 billion.

These small cap companies,listed on the National Stock Exchange, typically within positions of 251 to 500, represent a relatively untapped opportunity for wealth creation in bullish market scenarios, provided investors are committed to the long term.

Here are a few reasons why small cap investments are gaining appeal among savvy investors and how they can contribute to diversified, long-term portfolios.

• Growth potential: Small-cap stocks are often characterised by higher growth potential compared to their larger counterparts. As these companies are in the early stages of expansion, they have more room for growth and can demonstrate rapid revenue and profit growth in the long run.
  
• Undervalued opportunities: Given their diminutive nature, the small-cap market is less followed by analysts and investors, leading to instances of undervalued gems waiting to be discovered. Investing in these hidden opportunities can lead to significant gains as their value is realised by the broader market.
  
• Limited institutional ownership: Small-cap stocks tend to have lower institutional ownership, which means their prices are less influenced by institutional trading activities. This lower level of institutional ownership can lead to reduced volatility and more stable long-term returns.
  
• Diversification benefits: Including small-cap stocks in an investment portfolio can provide diversification benefits as they have a lower correlation with large-cap stocks, providing a hedge against market fluctuations and reducing overall portfolio risk.
  
• Historical performance: Between February 2004, and July 2023, the Nifty small-cap 100 index surged from a mere 832.06 points to a magnificent 11,572.40, indicating an almost 14X growth over the last two decades. In comparison, the Nifty midcap 100 has risen from 3663 points in 2005, to 36,720.85 in 2023, exhibiting a 10X growth. Coming to the large cap segment, the Nifty 50 has depicted an 11X growth, between 2004 and 2023, rising from 1,771.90 points to 19,666.45. Across the board, the small-cap index has exhibited higher growth than its larger peers, potentially aided by its nimble size and adaptive nature.
  

Cusp of a boom

The performance of small-cap stocks is intricately linked to economic activity and therefore, when economic conditions are favourable, small-cap stocks tend to thrive due to various factors such as robust economic growth, and stable interest rates. India’s current economic expansion presents an opportune environment for small caps to benefit from increased consumer spending and business investments. Stable interest rates further foster access to capital at attractive costs, stimulating business growth and expansion for small cap stocks.

Separately, small-cap stocks have historically shown their strongest performance during the early stages of economic recovery for, as the economy picks pace, smaller companies can experience rapid growth, boosting their stock prices. In addition, economic growth often spurs an increase in mergers and acquisitions, making smaller companies with innovative products or technologies attractive acquisition targets for larger enterprises. This could lead to potential windfalls for small-cap investors who get their skin in the game at an early stage.

Risks and considerations

Even as the sky remains the limit for small-cap stocks, investors must recognise the underlying high risk and uncertainty. Even as the economy remains conducive, small-caps may still face challenges in accessing funding, navigating competitive markets, and sustaining growth over the long term. Therefore, if you are keen on small cap investments, do undertake due diligence and research to make informed decisions and achieve optimal outcomes.

Overall, small cap investments offer an attractive path to long-term wealth creation, driven by their growth potential, undervalued opportunities, limited institutional ownership and diversification benefits. As the economy grows, small-cap stocks stand to benefit, though investors must be mindful of the associated risks. Hence, by carefully adding small-cap stocks into a well balanced investment strategy, savvy investors can unlock the potential for sustainable returns over time.

Disclaimer: The article is authored by Pradeep Thadani, Director, Psquare Money Pvt Ltd. The opinions expressed are those of the author and do not necessarily reflect the views of Business Insider India. Do your own research (DYOR) before deciding to invest in any financial asset class.