As the name would indicate, a small cap company is one with low market capitalisation. A company’s market capitalisation can be low for various reasons. This could be because the company is small or its is unprofitable or it is not widely held and researched.

Investments in small cap companies have traditionally been considered to be riskier than investments in the more liquid companies with larger market capitalisations. This is because, by their very nature, small cap companies do not have a widespread shareholding, do not attract widespread focus and research and hence are susceptible to imperfect information flows. It is felt that small cap companies have sharper market movements -–both on the upside and on the downside owing to these various reasons.

The Indian stock markets have passed through a prolonged bear phase during the period 2002 to 2003. During this period, owning to investor apathy, many companies witnessed their prices and valuations (price to earnings multiple, etc.) come down significantly. It has been traditionally observed that during bear phases, small cap valuations typically suffer more owning to lack of investor interest and focus. Thus, when the markets have come out of this prolonged bear phase during the recent months, these small cap companies have witnessed a correction in valuations and hence we have seen a sharp run-up in prices.

One must quickly say that as in any class of investments, there are high quality and poor quality companies in the small cap sector. Therefore, investors need to take care before investing in these small cap companies. As these companies are relatively poorly researched and less understood by investment analysts, the chances of price swings over and beyond those dictated by fundamentals are possible. Typically, investment analysts exercise greater caution and are very choosy before buying or recommending small cap companies.

In fact, in the Indian market, there are several funds which specifically focus on mid-cap/small cap companies. These funds are widely understood to be relatively riskier than their large cap and more diversified counterparts. We have witnessed several cases of companies which have been well managed over a period of time and have progressively increased market capitalisation and moved from being a small cap company to being very large cap companies. Several examples of companies which were regarded as small cap are available in the Information Technology sector. Many of these companies are now having market capitalisations among the largest in the space. Thus, to say that small cap investments are inherently riskier and investors should completely stay away form them may not be appropriate.

As mentioned earlier, several small cap companies have created enormous wealth for investors who were careful enough in researching them and in holding them over a long period of time. Some of the greatest success stories in all stock markets relate to small cap companies who have been able to create wealth for their patient shareholders. However, for every such company where shareholders have burnt their fingers owing to poor performance.

On balance, therefore, looking at the current rally, caution is warranted specifically for investors who want to directly invest in small cap stocks. Investors would be well advised to research companies thoroughly, vis-it their website, take advice of professional financial analysts and restrict exposure to individual companies. A diversified portfolio always has a lower risk profile than a concentrated portfolio. Since most investors do not have the time or the skills to do in-depth analysis of managements and industries relating to these small cap companies, they would be well advised to take help of professional financial planners and fund managers.

Mutual funds today offer a range of products to suit an investor’s risk appetite, both in small cap and large cap companies. An ordinary equity investor would be well advised to consider investing through mutual funds as also investing in both large cap as well as small cap funds so that risk is diversified.