In buoyant markets small cap stocks draw investors in droves but their returns don’t justify the risks.
In the real world, Davids don’t often slay the Goliaths. Few of the small caps, of the entire universe of minnows, ever make it to a large cap category. Sure, there are a few that do, and these deliver superlative returns, but for every one that does, there are probably a hundred or more that don’t.
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Hence, like in every broad-based market rally, this time too there is a hunt on for the next small cap multi-bagger, and there are names emerging on the investors’ radar of companies that few would have heard of in the past. I could name several of the buzzing small caps, but it wouldn’t be fair of me to club them together without doing enough study of their businesses and prospects, which is a time-consuming exercise.
So, I’ll refrain. But there are many out their being touted as big winners and hence the need for caution.
SMALL CAPS vs HEAVYWEIGHTS
There is a general perception that small caps give you much higher returns. If you are in the “inner circle” playing the rally with the big boys, most likely. But not in the long-term, data shows. And even in the short-term only if you are wise enough to enter and exit at the right time are you likely to make outsized gains.
We studied the returns given by the NSE Small Cap index and the Nifty since 2004, from when data is available for the small cap index, and we found that while the NSE Small Cap index has delivered a compounded return of 14.2%, the Nifty has returned 13.3%. That’s less than a 1% differential for significantly higher risk.x
A look at the BSE indices reveals a more worrying picture. While the BSE Small Cap Index has returned an absolute 32% gain since December 2017, from when data is available for the index on BSE, the Sensex has returned 79%. And the small-cap index has clearly also been more volatile.
What’s clear from the above is that a passive approach to investing in small caps may not be the best way to play the investment potential in this space.
SMALL CAPS ONLY FOR ICING
Having a portfolio loaded with small caps is not wise for most investors. Only professional money managers with the skills, time and resources should consider being overweight in small caps. Typically, small caps are identified by money managers and deep pocketed investors who engage deeply with company managements to understand the business, its potential and value triggers, before picking up sizeable stakes.
For them, even one winner from a pool of ten or more could be a good strike rate for returns. And for most of them, these are not basket buys but conviction calls after a great deal of study and engagement, so their probability of going wrong may be lesser than for those generally investing in small caps.
In the market, it has been a practice to track the investments by prominent money managers and follow their lead.
However, not having complete information about the perspective of such investors on individual stocks and their stance on them at different points of time can often land investors in a pickle.
Investments in small caps should therefore be done only after careful study yourself, if you are up to it, or by investing in a fund with a healthy track record of returns in the segment. Investing in small caps based on “tips” is a high-risk strategy that, more often than not, will come back to bite you.
Invest with prudence. Don’t let greed colour your judgement.
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