Small-cap Investing in 2020: Know How to Invest in Small Caps

Experts believe that small caps are all-set for recovery in 2020. While most small-caps underperformed throughout 2019 and even 2018, they have probably bottomed out and can outperform large-caps and mid-caps this year.

In the last 3-months, the S&P BSE Small-cap index gained almost 10%. In the same period, the frontline BSE Sensex gained around 1.3%. After underperforming in comparison to larger caps for nearly two years, it looks like the small-caps are up for the long-awaited recovery.

This can be an excellent opportunity for long-term investors to start investing in small-caps. You can do this either by directly investing in quality small-cap stocks or selecting a top small-cap mutual fund. Here are some expert tips on how to invest in small caps:

Improving Revenue Growth is a Big Plus

Small-cap companies are generally young. They aim for aggressive expansion and growth. The revenue growth of a small-cap company usually provides excellent insights about its progress. If the revenue is consistently increasing with every financial year, this is a big positive sign.

Falling Debt is a Sign of a Growing Company

Most small companies have limited funds and rely on debt for their growth. If the company has substantial debt liabilities, the interest takes up most of the revenue. On the other hand, if the debt is falling and the income is consistently increasing, the company could be the right choice for your portfolio.

Low P/E ratio stocks are generally undervalued

The P/E or Price-to-Earnings ratio is critical in analysing any company. It measures the valuation of the company in terms of its current stock price and earnings. Companies with a low P/E ratio are considered to be undervalued and suitable for investment.

Generally, investors compare the P/E ratio of the company they are interested in with the P/E of other companies in the same sector.

Prefer stocks with a low P/S ratio

Newer companies often do not generate a lot of revenue. But, that doesn’t mean that such companies could not grow in the future. If you are analysing one such company, the Price-to-Sales ratio can be beneficial. It is calculated by dividing the market cap of the company with its revenue.

Companies with a lower P/S ratio are considered to be favourably valued over companies with higher P/S. But do note that the P/S ratio varies significantly between industrial sectors. So, only consider comparing P/S of companies from the same industrial sector.

For investors who don’t want to invest in small-cap stocks directly, they can also opt for investing through small-cap mutual funds. Here are a few tips for selecting the top funds:

Diversified Funds

Just like small-cap stocks, small-cap funds are riskier than large-cap and mid-cap funds. So, it is always better to select a fund that has spread its portfolio across different industrial sectors. Over-exposure to any particular sector could be very risky in case one specific sector fails to perform.

Check the Financial Ratios

Just like the financial ratios of stocks, there are financial ratios for mutual funds too. Some of the most important ones for small-cap funds are:

• Sharpe Ratio-

  It compares the risk-adjusted returns of the fund. It is advisable to opt for funds with a higher Sharpe Ratio as they can deliver higher returns.

• Standard Deviation-

  It measures the rate of return with investment volatility. Schemes with lower Standard Deviation have less volatile price movements.

• Beta-

  Beta is the sensitivity of the fund in comparison to its underlying benchmark. Funds with Beta of above 1 are more volatile but also have more potential when compared to the underlying benchmark.

• Alpha-

  Alpha is the profit-generating ability of the fund when the underlying benchmark is generating profits. Funds with Alpha above one can generate higher returns than its benchmark.

• R-Square-

  Measured in percentage, it shows fund returns that are in line with its underlying benchmark. If the fund has an R-Square of 100%, the gains by the fund and its underlying benchmark would be the same.

Check the Historical Fund Performance

It is essential to check the performance of the scheme you are interested in across the market cycles. The scheme should not just be able to deliver high returns during the bull market but should also be able to manage the downfalls effectively. Look for consistency in the returns over 3-5 years. Avoid selecting schemes based on their recent performance.

While small-caps can outperform in 2020, risk-management is the key to making the best use of this opportunity. There are several stocks and mutual fund schemes, and several different ways to approach small-cap investing. But it becomes essential for any investor to consider their risk appetite, investment horizon, and financial objectives before making any decisions. The higher returns potential of small-caps comes at a cost and only get into them once you are fully aware of the upsides and the downsides.