In the risky world of investments, dominated as it is by large-cap plays, is there scope for small- and micro-cap stocks? Opinion seems to differ on that one, especially when such stocks are generally known to carry far greater risks than any other category of stocks.

It is not that small-caps or micro-caps have no merit at all – on the contrary, these securities can (and do) sometimes propel returns to reach new highs. The fact that this does not happen too often makes good small-cap stocks a fairly rare commodity.

Small-cap companies, as everyone would agree, are largely under-researched. They are not monitored too frequently, and their results are not tracked with the same zest as their large- or medium-cap counterparts.

Imagine, then, the kind of returns that a small-cap equity fund may provide over a period of time, if conditions are right for its performance. But as experts would no doubt suggest, such a fund is not likely to attract investors of every hue. In other words, only those who have the right risk-appetite will want to include a typical small-cap fund in their portfolios.

So, despite all seemingly bleak reviews, what makes small-cap counters tick? Well, these stocks are expected to possess re-rating potential. We will use an example here: Let’s imagine that a small, new telecom company, which has recently hit the market, is being taken over by an established telecom giant. The development leads to an immediate re-appraisal; it stock is lapped up by investors who want, in their own ways, to capitalize on the deal. That small-cap play is immediately seen as prospective medium-cap scrip. An equity fund that has included it in its portfolio stands to gain in the process.

In recent years – especially since the beginning of the great reforms process – Indian enterprise has thrown up many start-ups, a section of which has generated listed and publicly-held ventures. In many ways, these ‘emerging companies’ reflect entrepreneurial talent. Sectors that have clearly benefited include infotech, telecom, education and retail. Segments like media, hospitality and real estate have gained too.

Given the plethora of exemplary companies, investors are likely to be tempted to buy units of small-cap/micro-cap funds. They would do well to follow a few norms. Here goes:

• Do not make such a fund your core holding. The conventional logic is that a small-cap option should act as a value-addition of sorts. Large-cap funds, comprising heavy-weight, well-researched stocks, should form the core.
• Do not buy a small-cap fund without realizing the risks involved. While this is true for all investments, the existence of risky small-caps makes the age-old truism really worth believing. Further, be prepared to wait for a long period for genuine returns to happen.
• Liquidity is a particularly tricky issue for small-caps. Low liquidity is a curse for many emerging enterprises. As an investor, you need to be aware of this matter; also, if you buy too quickly, you may fail to secure a good price when you are trying to exit early.

Seasoned investors suggest that investment in small- and micro-caps is often a matter of stock selection, not sectoral allocation. In elaborate further, each case would have to be separately weighed, explored, probed. There is no way a professional fund manager would invest on the basis of an asset allocation strategy.

This is principally because small-cap companies, even when they are growing rapidly, are susceptible to many pulls and pressures. Remember, many such companies (typically, they face substantial entry barriers) are constrained by poor resources. They often fail to tap growth opportunities effectively because of this.

Small outfits sometimes fail to invest adequately in technology, marketing, brand-building and so on. Their volatility on the bourses often invites trouble – by and large investors suspect these companies, simply because they are too small for their comfort.

A small-cap may, over a period of time, emerge into a giant on the stock market. However, still such a time that happens, it may well remain characterized by a single epithet: “high-risk, high-returns”. A fund manager must exercise extra caution when it comes to buying such a stock. And, for an ordinary investor, small-cap funds are rather risky propositions. Their portfolios and historical performance must be adequately analysed before such funds are made part of an investor’s holdings.

A diligent fund manager will find smart ways to diversify within the world of small- and micro-caps. It is not that diversification is exceedingly difficult here; with so many sectors growing rapidly, it is easier these days to diversify than before.

Before we end, let’s cite a few real-life cases. DSP BlackRock’s micro-cap fund, for instance, is fairly well-diversified, with its assets invested in engineering, chemicals, construction and FMCG. A near-similar fund managed by IDFC has investments in finance, healthcare and textiles. JM’s fund holds construction, auto and communications. However, the last-named fund has performed poorly since its inception in April 2007.