Pack a punch with small caps

Nitish Mehta is a small investor in the equity market. He is a regular trader, buying and selling almost every other day but not every day like a day trader, he explains.

He typically identifies small value companies, watches the price and volume trend closely and tries to ride the sudden spurt or rally that many of these small scrips witness.

He has been largely successful in the last two years, riding the broader equity market rally.

But in recent times, he has noticed that most of these small value counters have already seen a substantial jump in volumes and prices and by the time he identifies and buys some shares, the subsequent gains in the prices are not very significant. Infact in many cases his bets have also gone wrong.

Mehta is not the only one buying these small value companies, hoping to ride the rally.

Typically not much research is available on these small-cap counters and small investors tend to buy these shares as the 'value' per share is low and there is significant activity in these counters.

But fund managers warn that most of these investors are playing into the hands of operators and strongly recommend that even small companies must be researched to a certain extent before one invests in them.

Annual reports are a fair indicator of the company's performance and the least an investor can do is have a look at the performance of the company before investing in it, they add.

Digest this: The benchmark Bombay Stock Exchange (BSE) Sensex may be in correction mode, trading at the same levels as at the beginning of January but for 633 small companies with a equity base of less than Rs 10 crore have a different story to tell.

These companies have recorded a 35 per cent gain between January 3 and March 21, outperforming almost all major indexes.

But not all small-cap companies are operator driven. While the popular perception is that small caps are risky, frequently fraudulent and lack a minimum quality that investors must look for, some companies also have very strong fundamentals and growth prospects.

As many mid-caps have now become large-caps, many small-caps have the potential to follow the same growth path.

Brokers also point out that it is important to make the distinction between small caps and penny stocks: You can be a small cap without being a penny stock, they add.

Why think small?

The argument over investing in small-cap companies will always go on but there are some factors that are essential to consider before taking the plunge in the shallow end of the pool.

Small-caps can have a huge growth potential, having the ability to grow in ways that are simply impossible for large companies, due to their sheer existent size.

Another advantage is that large institutions cant invest huge amounts in small-cap companies as they don't have the market cap to support this size of investment. This gives an advantage to individual investors who have the ability to spot promising companies and get in before the institutional investors do.

When institutions do get in, they'll do so in a big way, buying many shares and pushing up the price, market entities say.

The fact that they are small companies also has its advantages as many have not noticed them and as a result not much information or research is available. This can give the small investor an opportunity to identify and take advantage of a price incongruity.

But there are risks involved in investing in small-cap companies. Not all of them go on to become big-caps besides your risks are also higher as compared to investing in larger cap companies.

Small caps are also more susceptible to volatility, simply due to their size and it takes less volume to move prices, analysts say.

Besides, it also takes longer to unearth a good small cap company and lack of readily available information can be a major deterrent, they add.

Most successful large-cap companies started at one time as small businesses.

You can start at the shallow end and graduate to the deep end but the chances of hitting the bottom are bigger if you take a blind plunge in the shallow end, warn fund managers.