What are the top Small Cap Stocks to Invest in 2023?

In the diverse landscape of the Indian stock market, the Securities and Exchange Board of India (SEBI) categorizes firms with a market capitalisation below Rs. 5,000 Crore as Small Cap companies. Surprisingly, such companies, making up over 95% of all Indian firms, demonstrate the dynamism of our economic structure. Often ranking beyond the 251st position in terms of market capitalisation, these companies tend to excel in the early phases of economic revival. Their publicly traded shares, known as small-cap stocks, could be the potential key to growth.

If you are considering incorporating small cap stocks into your investment strategy, it is beneficial to understand their nature, factors to consider when selecting smallcaps and associated risk factors. Collaborating with a financial advisor can also assist in determining the appropriate investment combination to align with your long-term objectives.

Why Consider Small Cap Stocks

Small cap stocks are a category of stock investments that consist of stocks from smaller companies. They possess distinct characteristics that set them apart from large cap and mid cap stocks. Investing in smaller companies offers several advantages such as –

Inherent Growth Potential

Small-cap firms usually harbour significant growth prospects. Large cap companies have already experienced substantial growth and may have limited room for further appreciation in share prices. Conversely, smaller companies have the potential for significant growth and price appreciation in the years ahead. Investing in small cap stocks allows individuals to seize opportunities early on with emerging companies. By purchasing and holding shares of smaller companies, investors can benefit from potential future growth and value appreciation. If the company succeeds, it may eventually transition from small cap to large cap status.

Higher return potential

Market inefficiencies may offer high-quality smallcap stocks at more affordable prices. While large cap companies can provide stable returns and potentially offer income through dividends, small caps historically outperform larger companies in terms of average annual returns. Smaller companies tend to be more agile than their larger counterparts, allowing them to adapt quickly to market cycles, introduce new products or services, or undergo internal restructuring as needed. These factors contribute to the potential for small cap stocks to deliver better performance within their specific market segment compared to larger competitors.

Less competition from Institutional Investors

Institutional investors, such as banks, hedge funds, and real estate investment trusts, often overlook small cap stocks due to their size. Additionally, regulatory restrictions restrict these investors from heavily investing in small caps. This creates an opportunity for individual investors to enter the market and potentially witness the growth of small companies over time.

Factors to Consider When Selecting Small Cap Stocks

You don’t need to tune into a finance TV show or a Youtube video to hear about the next big ‘guaranteed’ method promising to make you a millionaire overnight. Instead, focus on fundamentally strong businesses with a diversified product range, profitable operations, and a robust market position. Such companies are most likely to be a worthy investment. The rest 10% of your decision-making process should focus on some specific metrics to determine if it’s the best stock for your investment.

Here are the 9 essential metrics that will help you understand the company, its operations, and the underlying business better:

1. Institutional Activity: Massive share transactions by institutions like pension funds, mutual funds, hedge funds, insurance companies, and corporations can result in significant price fluctuations. Aim for companies where institutional ownership is less than 40% of the shares.
2. Analyst Coverage: The number of analysts tracking a stock can indicate future share volatility. It’s prudent to avoid companies with more than 10 or fewer than 2 analysts following them.
3. Price-Earnings Ratio (P/E): The P/E ratio, a popular financial metric, determines whether a company’s shares are overvalued or undervalued. If the P/E exceeds 35, the shares might be too pricey, especially for beginner investors.
4. Cash Flow: A positive Total Cash Flow From Operating Activities figure or a trend in that direction over a year is preferable.
5. Debt/Equity: This ratio signifies the business’s debt for each dollar of ownership. Examine if the company’s debt level has been escalating too quickly over the years.
6. High Operating Margin: A consistently increasing operating profit margin indicates the profitability of the business and can be a promising investment opportunity.
7. Rising Sales and Profits: Small-cap companies heavily rely on their sales due to limited cash reserves. Look for companies whose sales and net income are growing at double-digit rates.
8. Quality of Management: Corporate governance and quality of management are critical. Conduct a thorough background check of the company’s promoters and management before investing.
9. Insider trading activity: High levels of insider selling could be a red flag, while insider buying could suggest that the company’s leaders believe the stock is undervalued.

Armed with these key metrics, you’ll be well-prepared to make informed decisions about small-cap stocks. Remember, “Knowledge is power!” Embark on your investing journey, and let your portfolio do the talking!

Top Small Cap Stocks to invest in 2023

The top small cap stocks to invest in India can vary over time, as stock market conditions and performances change. It’s important to conduct thorough research and stay updated on the current market trends. Here’s a list of top performing smallcap stocks that have done well this year:

1. Delta Corp: A holding company operating in the casino gaming industry in India. It has divisions for casino gaming, online skill gaming, and hospitality services. Giving 16% return over the last 6 months and 10% on a year-to-date basis
2. VST Industries: VST Industries Ltd. is a conglomerate company based in Hyderabad. It is primarily involved in the manufacturing and distribution of cigarettes. Giving 6.93% return over the last 6 months and 5.12% on a year-to-date basis.
3. Bajaj Consumer Care: Bajaj Consumer Care Limited is an FMCG company specializing in the manufacturing of hair oils and personal care products, including the well-known brand Nomarks. Giving 14.49% return over the last 6 months and 9.69% on a year-to-date basis.
4. PSP Projects: PSP Projects offers construction and allied services across various industry segments in India, including industrial, institutional, commercial, residential, hotels, and government projects. The company has a cash-rich balance sheet, ensuring financial stability and healthy revenue visibility. With its solid execution capability and growing order book, PSP Projects is well-positioned for future growth. Giving 14.26% return over the last 6 months and 8.40% on a year-to-date basis.
5. Maharashtra Seamless: Maharashtra Seamless is a prominent steel company operating in the casino gaming, hospitality, and online skill gaming segments. The company has experienced consistent sales and profit growth over the past five years, with a notable increase in promoters’ stake, indicating confidence in the business’s future prospects. However, it is exposed to the cyclicality of the oil and gas industry and fluctuations in input prices. Giving 58.42% return over the last 6 months and 47.59% on a year-to-date basis.
6. Arman Financial Services: Arman Financial Services is a mid-sized non-banking financial company (NBFC) that focuses on serving the financing needs of rural and semi-urban retail markets. With a strong presence in multiple states and a conservative approach to high-yielding assets, the company has demonstrated sustainable returns on assets (ROA). However, the company is susceptible to any downturn in the microfinance industry and has a concentrated geographical presence. Giving 42.76% return over the last 6 months and 37.31% on a year-to-date basis.
7. Mold-Tek Packaging: A leading player in rigid packaging, serving industries such as paints, lubricants, food, and FMCG. Mold-Tek Packaging is well-positioned to expand its market share and target new growth opportunities in the packaging industry. However, the company faces risks related to its high dependency on one key customer and regulatory concerns regarding the use of plastic-based products and raw material price volatility. Giving 12.64% return over the last 6 months and 3.77% on a year-to-date basis.

Here is a list of the top smallcap picks by investment managers & money managers across portfolio management schemes, mutual funds, AIF & ULIPs for the month of May 2023. These selections reflect the preferences of market participants for promising small-cap stocks during that period.

In May, Indian mutual funds and portfolio management scheme (PMS) managers identified Equitas Small Finance Bank, Birla Corporation, and Sanofi India as their top new small-cap picks for 2023. Equitas SFB garnered attention from 9 mutual funds, 10 PMS, 13 unit-linked insurance plans, and one alternative investment fund. Birla Corporation was picked by 4 mutual funds, 2 PMS and 10 ULIPs, while Sanofi India was picked by 6 mutual funds, 2 PMS and 7 ULIPs. Additional small-cap picks included Indiamart Intermesh, Affle India, VIP Industries, Birlasoft, Can Fin Homes, PVR, Inox, and Exide Industries.

Risk Factors to consider while investing in small caps

Historically, small-cap stocks have shown a consistent trend of higher returns compared to large-cap stocks due to several factors:

1. Market Risk (Beta): Small-cap stocks typically exhibit higher market risk or beta. They are often less established, have unstable financials, and seldom pay dividends, leading to increased market risks.
2. Liquidity Risk: Small-cap stocks have a higher liquidity risk due to a narrower investor base, making them less liquid assets.
3. Information Risk: The lack of coverage or ‘information risk’ can deter some investors as small-cap stocks are often less covered by analysts and financial reporters.

The aforementioned risks lead to the potential for higher returns, aligning with the risk-return tradeoff principle. Essentially, the greater the risk, the greater the potential return, and small-cap stocks certainly carry their fair share of risk. However, these incremental returns may compound to significant differences over a long period.

Despite these risks, the less followed nature of small-cap stocks can also present opportunities. With fewer analysts tracking them, these companies may have undervalued aspects that the market hasn’t fully recognised yet, leading to potential profit opportunities for perceptive investors.

As such, while investing in small-cap stocks does present unique challenges and risks, the potential for higher returns compared to large-cap stocks has been a compelling historical trend. As always, a well-diversified portfolio and careful consideration of individual financial circumstances and risk tolerance are key elements of successful long-term investing.

Conclusion

Investing in small-cap stocks can provide excellent long-term investment opportunities. For investors looking for exposure to small-cap stocks, index funds are often a viable and straightforward option. These funds offer diversification and typically come with relatively low costs. Alternatively, investors can consider actively managed small-cap mutual or exchange-traded funds. A common strategy employed by investors is to buy a basket of small, young firms in a rapidly growing industry, then reinvest in the firms that emerge as winners as the industry matures.

Small-cap investments do carry a certain level of risk, and many end up losing money or going out of business. However, those that succeed can offer significant returns. Just as a cricketer doesn’t need to hit a boundary on every ball to have a high batting average, investing in small-cap stocks doesn’t require every pick to be a winner in order to generate a winning long-term return. Even if some investments fail, those that succeed can provide substantial returns and boost the overall performance.

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