Guest post by Sweeney Kamur
Investing in the equity market is one of the most common forms of investment. It is highly recommended for its high rates of return; however, equity investing comes with high levels of risks as well.
Many equity investors prefer investing in blue-chip companies due to their strong balance sheets, proven performance records, and history of high dividends. However, small-cap companies are also an excellent avenue for equity investment.
Small-cap stocks are the stocks of companies with a market capitalisation between $300 million to $2 billion; £250 million and £1.5 billion. Such companies are small in size, but it does not mean that they are just new companies.
They are usually well-established firms, with proven business models and strong financial performances. Therefore, investing in small-cap stocks should not be confused with investing in start-ups and they do not have to be penny stocks.
Small-cap stocks can either be publicly listed on the FTSE Small Cap Index of the London Stock Exchange or the Alternative Investment Market (AIM). Some of the small-cap companies can also be private yet offering private investment opportunities to investors.
small-cap stocks are usually undervalued, and the price inefficiency brings good buying opportunities for well-researched investors
Thus, investors can invest in small-cap stocks listed on AIM or invest in small cap mutual funds with holdings in a wide variety of small-cap companies in different sectors. Additionally, investment in small-cap stocks can also be made by investing in passive exchange-traded funds (ETFs) or funds that track the performance of the small-cap index.
Investing in the small-cap equity market has its fair share of pros and cons. On the one hand, small-cap stocks are the go-to investment options for growth investors, but on the other hand, they are more risk-prone compared to the large-cap companies.
Small-cap companies tend to earn money and grow faster than big businesses due to their innovative and dynamic approaches. They are, therefore, excellent additions for the diversification of portfolio for investors looking for rapid growth.
Moreover, small-cap stocks are usually undervalued, and the price inefficiency brings good buying opportunities for well-researched investors. Small-cap stocks have a low initial capital requirement and yet outperform many large index funds regularly. They also do well with low interest rates.
However, the risks associated with investing in small-cap equity market should not be overlooked. The small-cap companies are smaller than the big giants and have lower cash reserves, smaller economies of scale, and less diversified streams of revenue.
They do not have substantial financial backing to weather losses and may even cave in under challenging circumstances. Additionally, small-cap stocks suffer from liquidity risk.
The shares of small-cap companies have fewer buyers and may not find the right buyers at the right price when you require liquidity. Small-cap stocks are also less suitable for income-oriented investors as they usually do not provide dividends and the profits are often reinvested into the company for growth.
The consideration of risks and rewards of investing in the small-cap equity market has intensified in the current economic conditions. With greater recessionary concerns due to the COVID-19 pandemic, the value of the small-cap companies has significantly declined.
The equity markets have become highly volatile but small-cap stocks have managed to outperform the large-cap stocks. Examples of small cap investments include BlackRock Smaller Companies, FTSE Small Cap index, iShares MSCI United Kingdom Small-Cap ETF and Liontrust UK Smaller Companies fund
Therefore, if the small-cap companies survive the storm and do not get delisted, they should bounce back at the end of the recession. Investors must perform stringent due diligence before investing in small-cap stocks during this time.
You must analyse the company’s financial performance, the value of debt, earnings, and other parameters to understand if it is strong enough to beat the ongoing economic downturn and recuperate. Evaluate the risk and return, the cost and your investment goals before diving into small cap investments.