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Large companies attract most of the attention, but a significant share of wealth creation in India has come from businesses that began as modest enterprises. While the BSE Sensex tracks the biggest names, other benchmarks capture the middle and lower rungs of the market. The broader family of BSE Indices includes dedicated gauges for mid-sized and small companies, offering a window into the more dynamic and more volatile part of the equity universe. Understanding how these benchmarks behave can help investors decide how much risk to take in pursuit of higher returns.
Defining the Segments
Companies are classified based on market capitalisation. Large-cap firms are the biggest, most established ones. Mid-cap companies are middle-size leaders in their niche, with room to grow. Small-cap companies are small, sometimes young or specialised.
The official categorisation in India is based on the ranking of market value, and is periodically updated by regulators and the industry. This means that a company can move from one category to another as it grows or shrinks.
The Case for Growth
Smaller companies have more room for growth. A company with smaller revenue has more opportunities to grow and become bigger. Such an example could be a mid-sized manufacturing company that grows its sales base by entering new markets, or a small financial company that extends its lending books.
Many market leaders of today were once small companies. The investors that invested early and held on to their shares reaped rich rewards. Mid- and small-cap market indices, over certain periods of time, have outperformed large-cap indices, making them more popular investment choices.
The Other Side: Volatility and Liquidity
Big potential means big risks. Companies of smaller market capitalisation have less diverse operations and poorer balance sheets, meaning one misstep can make for big losses.
Such companies also have fewer shares outstanding at any given time, meaning larger sells or buys can move the price significantly. Especially during periods of stress, such a situation can cause the value of the shares to plummet, with few buyers ready to step in. Small-cap indices have seen drops of thirty to forty per cent at times, leaving even seasoned investors green with envy.
Governance quality can also be an issue, as the coverage of researchers and media is lower, and promoter activities are less visible. Therefore, due diligence is of paramount importance when investing in small companies.
Valuation Awareness
It’s easy to get carried away during a rally. When the price-to-earnings multiple of a segment greatly exceeds its historical averages, it’s important to understand how much of a stretch the current fundamentals allow for. Always consider valuation when comparing multiples of similar segments, and understand whether earnings growth justifies the level of the stock. Valuations do not time the market, but give a sense of how much downside protection there is.
Sizing Your Exposure
A responsible approach to small-cap stocks is to limit the size of your exposure to them. If you’re a long-term investor with a high risk tolerance, you can allocate a significant chunk to the small and mid-market segment. Someone who is close to or beyond retirement age, and has little income to reinvest into the market, should limit their exposure. Many financial planners advise keeping the majority of one’s equity portfolio in large, mature companies, and to use small- and mid-cap as a diversification tool.
Systematic investing helps to control the risks posed by the volatility of small market-cap stocks. The fixed monthly allocation allows you to purchase more shares when the prices are low and to average out your purchase price. Mutual funds that invest in small market-cap stocks offer diversification, as they invest in dozens and even hundreds of different companies, which is much safer than investing in individual shares.
Time Horizon Is Everything
Market leaders of today were once small companies. Small market-cap companies have long growth trajectories ahead of them. It’s important to have a seven-year investment time horizon at minimum when investing in small market-cap stocks. If you need the money sooner, it’s better to steer clear of this segment.
Review your holdings every year, keeping an eye on developments in the business rather than the price movements. Be prepared to weather large downfalls in the value of the shares. Used wisely, small- and mid-market-cap indices and their constituent companies can add growth to your equity portfolio, whereas unwise allocation can teach you a costly lesson.
