Many new comers in the stock market are lured by the romance of finding that elusive small cap stock that can multiply several times (known in industry parlance as a ‘multi-bagger’). If Lady Luck sides with them in the beginning and they hit a few early jackpots, they parade their success as a symbol of having arrived on the investing scene! Little do they realise what lies beneath the truly enduring success stories.
Why investing in beaten down small cap stocks is not so easy after all?
On the surface, investing in small caps may seem obvious:
1. Small caps are under-researched, under-owned and hence more under-priced.
2. Law of small numbers and small bases works well to multiply investor returns.
Everyone knows that stocks picked at the bottom of a bear market are likely to do well. This is especially true for small caps, as this segment takes the biggest hit. Since their peak levels in January 2018, over 70% of the 100 Nifty Small cap index stocks are in losses. The average fall for these stocks is well over 40%. The question is, which one to pick?
There are multiple challenges in small caps: first, the fundamentals can quickly deteriorate if there is a change in the industry dynamics or a balance sheet/corporate governance issue. Second, your entry price can really make or break your small cap stock’s return. Often times, investors end up picking a stock in a hot/trending theme, only to end up buying it at expensive valuations. Third, it can take years before a small cap stock really starts appreciating. In such cases, the annualised return on this stock would be less stellar than the stocks of stable and compounding larger companies.
Now, lets say that you cross the aforementioned hurdles and do pick a small cap stock that does indeed appreciate meaningfully in value. Even the most ardent and experienced small cap investors will admit that the period of brilliance in performance of small caps is limited and can shift very swiftly. Even if you do sell at an opportune time, liquidity can dry up in the stock and have a negative effect on your selling price. Only a handful of small cap companies are truly enduring over long periods of time.
Wanna follow the savvy investors and make money? Then follow their mindset as well!
Dewan Housing, Jet, Jaiprakash Industries, Reliance Defence, Prakash Industries, IVRCL, Bilcare, A2Z, Viceroy Hotels, McNally, Mandhana, Provogue, Prime Focus, Lupin, Man Infra, Titan, Prozone, Crisil, Adlabs. These are the picks of one of India’s most well known stock market investors. Of these only Titan, Crisil and Lupin have truly made mutli-bagger returns. And this gentleman has held these 3 companies through thick and thin over the last 17 years. The others have fallen by the wayside.
The moot point here is that given the uncertainty in small caps, its important to hold a basket of them instead of buying only one or two of them. And the hardest and most difficult part is to sit through these stocks in periods of volatility over long periods of time. That is much easier said than done.
I am not saying that investors should not invest in small cap stocks. They should do so only after thorough research, due diligence and understanding of the entry price. Good small cap companies can indeed make handsome over periods of time. My suggestion is that while investors should continue their search for stellar small cap companies, they should invest a chunk of their portfolio in relatively stable large caps that can compound meaningfully over a period of time.