10 Key Things You Need to Keep in Mind While Picking a Small Cap Stock

10 Key Things You Need to Keep in Mind While Picking a Small Cap Stock

How accurately do you define small-cap stocks in the context of India? There are various definitions, but large-capitalization is a term used to classify companies with relatively small market capitalization.

For your safety, you can easily consider stocks with a market capitalization of Rs 2000 to Rs 5000.

Of course, you need to do your homework before investing in these stocks online, but here are 10 things to check when buying small-cap stocks in the stock market.

1) Time Horizon

Before buying any stock, you exactly need the time horizon as it will help you decide up to what time you should hold the stock.

Time horizon can be divided into three types:

Short Term

An investment that you need to hold for 1 year comes in the short term. If you want to buy stocks that come under the short term horizon, then it would be best to invest in stable blue-chip stocks which give you good investments. These stocks hold a good balance sheet and also possess minimum risks.

Middle Term

People who want to invest in the middle term should invest in emerging market stocks and have a moderate level of risk.

Long Term

Long term investment stocks have the ability to generate long term stock market trading returns and have to recover if their prices go down due to volatility.

2) Check the Past Performance

Small-Cap stocks are the ones that have a small market capitalisation. Hence it is important to check the past record of any small-cap companies. Since the company stocks carry high risks, you need to carefully examine the stock’s fundamental analysis and technical analysis before selecting any stock.

Therefore it is suggested to invest in the small case stocks that have a good track record i.e at least of 5 years.

3) Investment Strategy

Before selecting any small case stock, you need to focus on the strategies which are used by most investors:

Value Investing

Value investing is mainly used by giant investors like Warren Buffet. This type of investing refers to the company stocks that are undervalued compared to peers in a hope of gaining good stock trading returns.

Growth Investing

In growth investing, people invest in stocks that show huge growth in terms of revenue and earnings. Investors firmly believe that any upward trend in these stocks will generate huge profits.

Income Investing

Income investing in the stocks that pay you high dividends. These are quality stocks and are investors’ favorites because the income generated by these stocks can be reinvested for higher earnings.

4) Focus on Consistent Performance

Sometimes consistency matters more than absolute performance, especially in the case of small-cap stock.

Hence it is suggested to invest in the companies that have shown growth and have a good past track record and neglect the companies which have shown poor performance. It has been seen that the consistent small-cap achieves better valuations than the other small-cap stocks.

5) Look at the Fundamentals

It is good to check the fundamentals before buying any stock:

Price to Earnings Ratio

The ratio refers to the stock price with respect to the company’s earnings on an annual basis. For instance, if a company is trading at Rs 20 per share that generates  EPS of Rs 1 on annual basis; that means the share price is 20X times the company’s earnings calculated annually.

Debt to Equity Ratio

Debt to equity ratio tells how much the company is in debt. It is to be noted that high debt is bad as it leads to bankruptcy.

Price to Book Value Ratio

The ratio compares the stock price to the net value of assets that are owned by the company which is then divided by the number of outstanding shares.

6) Pay Attention to Market Size and Positioning

Small-cap companies are those that have a single product or single service as they don’t have much capital to expand their business. In this case, the size of the market matters a lot. Also, the company’s position in the stock market highly matters as it makes a countable difference to company valuations.

7) Check the Dividends

A dividend refers to a portion of profits companies share with their shareholders. They distribute profits in the form of dividends. Investors who are interested in dividend stocks should check the dividend history of the companies before going for any stock.

8) Check Contingent Liabilities and Auditor Qualifications

Contingent liabilities mean pending legal cases, open derivative exposures etc. Small-cap companies generally have contingent liabilities. Hence it is important to check whether a company is involved in any legal cases or not.

In addition to this, you need to check whether the auditor is not qualified or the auditor resigns from their position.

9) Volatility

Volatility badly affects small-cap stocks. The small-cap stocks with high volatility will rise on bullish days and fall drastically when the market gets into a bearish mode.

10) Keep Track of Cash Flow Statements

It is important to check the cash flow statements, especially in the case of small-cap stocks. As the small-cap stocks generally lie under liquidity constraints which means that the small-cap stocks are unable to manage their working capital effectively.

The Bottom Line

Small-cap stocks are highly volatile which makes them full of risks. It makes it difficult for investors to trade in small-cap stocks. However, you can select good small-cap stocks if you use these factors for stock trading.

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