The Benefits of Small-Cap Stocks in HNI Portfolios

28 Nov 2024 , 12:52 PM

For Indian high-net-worth individuals (HNIs) seeking to enhance portfolio returns, small-cap stocks provide alluring growth opportunities. Despite higher volatility than large caps, good small stocks have showcased superior long-term performance that can turbocharge already sizeable investment accounts. This blog post will help one examine why quality small-cap shares deserve a place in the portfolios of HNIs.

Understanding Indian Small-Cap Stocks

In India, the small-cap category comprises companies with total market capitalisations of up to ₹5,000 crores. Their relatively modest scale allows for expansion runways that large-cap companies no longer enjoy to the same extent.

Indian small-cap companies usually focus on domestic emerging niches, developing indigenous technologies, or serving underserved segments. Their maneuverability forms the basis for growth prospects that directly impact share prices.

Robust Returns

Analysing past data reveals why Indian small-cap exposure proves prudent for HNIs. Over the past few years, the NSE Smallcap 100 index generated higher annualised returns than the Nifty 50 large-cap benchmark. Compounding widens the outperformance gap, generating significantly higher returns for the Smallcap 100 index versus the Nifty 50.

Key Drivers of Outperformance

Several interlinked factors enable Indian small caps to produce standout gains:

• Agility to tap into domestic demand: Smaller firms can pivot faster to capitalise on emerging consumption trends in the market.
• Takeover appetites of large players: Ongoing consolidation sees leaders acquire smaller peers to expand their market share. These investors benefit from buyout premiums.
• Early business lifecycle status: Most small caps possess products that are gaining broader acceptance in the Indian market. As adoption accelerates, so do their financials and valuations.
• Entrepreneurial culture: Small caps often pioneer innovations or alternative models to solve local pain points, capturing first-mover advantages.
• Wider investment avenue: The small-cap investment sphere provides exposure to more stocks than just large caps, allowing HNIs to uncover hidden gems.

Risk Management for Small-Cap Investing

While small-cap stocks can appear riskier based on historical volatility and failure rates, small-cap stocks offer Indian HNIs the chance to reduce their overall portfolio risk through prudent allocation. The key lies in discipline. It is important to maintain a reasonable exposure that is guided by risk appetite. Recommended risk management practices include the following:

• Diversify across sectors, industries, and stocks.
• Focus on higher quality companies with durable and scalable advantages.
• Insist on strong financial health measured through metrics like operating cash flows and debt.
• Reinvest dividends and periodic gains to maximise compounding.

The risk-return profile of small-cap stocks can prove favorable for long-term investors able to digest phases of underperformance.

Constructing a Growth-Oriented Portfolio for HNIs

For HNIs, dedicating 15-20% of the equity portfolio to domestic small caps can help strike an appropriate balance. This can help them limit the overall volatility while still capturing excess return potential to accelerate portfolio growth.

Given the entrepreneurial dynamism shaping India’s business landscape, the rewards can be expected to continue to outweigh the risks over long horizons. Allocating a share of assets to Indian small caps provides diversification while tilting the portfolio toward higher growth.

Conclusion

For wealthy Indian investors seeking amplified growth, domestically focused small-cap stocks deserve inclusion in the portfolio despite higher volatility. A modest allocation in small-cap stocks can help optimise the risk-reward ratio over long durations. Savvy stock picking can help HNIs unlock the immense potential of India’s vibrant small-cap companies.

With prudent diversification and risk management, small-cap stocks can help tilt portfolios toward higher compounding. India’s entrepreneurial culture and expanding consumption provide fertile ground for dynamic small firms to deliver outsized returns. For HNIs, incorporating these emerging companies can accelerate their portfolio growth.