Curious case of small cap investments

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We have always maintained that small cap stock investment is way different from a large cap or vanilla stock investment approaches. This is very well understood at institutional levels but somehow when it comes to retail investors, people are happy to advise same approach for all. While basics remain same but mental model of a small cap investor has to be way different. It needs more mental toughness and firm belief to be successful small cap investor. There are not many text available on internet which focuses on pure small cap investment in India context. We are doing our bit as part of AI post to benefit our Ace Readers.

In this article, we will share why we think small cap investment is different and we hope you will benefit from it.

Don’t blindly follow media experts

You will recall that in television channels & newspapers, experts were promoting to buy small cap stocks over large caps during Oct-Dec’17 when they were at the peak. Some of them were cautioning that they are very costly and should be avoided. Fast forward to now, many experts are rallying behind large caps and cautioning investors to stay away from small caps. Does all this make any sense?

The investment in small cap is inherently different from large cap investment. Unfortunately, most people paint small & large caps with same brush. The very basic difference between them is the earnings growth potential.

A TCS or Infosys can generate $1 billion revenue every quarter but can they multiply it by say 2 times or 5 times within couple of years? This is unlikely because their growth has already been saturated. Unless they change business model, it is not going to increase drastically. Most largecap business want to maintain status quo and will fear to change a successful business model. This means growth will remain mediocre.

However, a small cap can double or triple their earnings within a few years as they are growing small caps companies with lower base. They will not hesitate to change business model to attain higher growth and hence investment approach to small caps should be different. Following typical model of buying when they become cheaper by 25% and sell as soon as they are 50% higher makes sense for largecaps. It’s very different in small caps, as they are projected to grow 5 to 10 times and if we follow largecap strategy and sell them at 50% profit, there are higher chances that we will miss next 450% on the offering.

So next time if you hear some expert saying small cap is cheaper or costly, don’t pay too much attention. Your focus has to be on the stock you own. Is that stock going to double its income, is it on track to leapfrog to next phase, what are the challenges it can face? As long as you remain focused on it, noise will not be able to distract you. Cycles come & go, but good stocks with revenue visibility will ultimately go up with a few intermittent hiccups.

It’s time consuming

There are only a handful of large or mid cap stocks which are very well covered by institutions or analyst community but small caps are mostly undiscovered and under researched. Mostly, as per market capital structure, top 75-100 stocks are qualified as large cap, next 150-200 are considered as mid cap. This leaves a huge 3500 odd stocks under small caps. The choice is plenty and of all types. This is goldmine for retail investor and there is not much competition but reaching here and finding out quality stock is going to be difficult. Most institutions will not bother to look over there. This results in painfully slow stock price appreciation for small or micro cap stocks. It takes time for a stock to mature & move up it’s market capital to get into notice. There are stocks which have been performing well but not getting deserving valuations because they are ignored. On the other hand, there are large cap stocks which are performing half as good but priced at premium valuations because they are getting noticed easily by deep pocket investors.

Ride is Bumpy

All of you must be aware that SEBI has re-classified mutual funds and as a result only small cap oriented mutual funds can invest into small caps. Others can not. This is bad for small caps as there are hardly much small cap oriented funds. At max, there may be 10-15 small cap mutual funds from the basket of 1000+ of mutual fund schemes. This is resulting in lesser mutual funds money chasing small caps. Mostly small caps are now driven by individual investors. Many of them are typically investing for short term and are easily consumed by greed & fear. The net result is small cap investment becoming very volatile. Lesser liquidity (number of shares traded per day) also does not help. As it takes only a few investors to panic for a lower circuit. There are stocks which have a few hundred shares exchanging hands everyday. A single sell order of few thousand can easily put stock into continuous lower circuits without respite. This often leads to domino effect as other investors also start dumping the stock due to panic.

It’s not perfect

Many small caps are run by first generation entrepreneurs who are too much engrossed into daily operations. Often, they do not put enough emphasis on marketing & branding of the company. They are media and analyst shy. This is easily visible in case of pure technocrats running the firm. Some of them are poor in corporate communication just because their focus is elsewhere. If we try to search for a small cap company which is perfect in every way, there are chances that we won’t find any. We have seen many small cap firms maturing their branding & communication as they grow in size. This helps to get more capital from investors but by this time some of the returns are already gone.

Conclusion

Small caps are like diamond stones in a mine, they are there but finding them needs skills and patience. Number of small cap stocks is very high and only a few will give you multibagger returns but they can potentially change your wealth profile forever. If you have a solid investment approach backed with patience, multibagger returns are yours.

However, most people don’t have so much time and skills to periodically skim through vast universe of 3500+ small cap stocks. It is best to take help from an independent stock adviser whose core competency is small caps research. Stay away from stock advisers who recommend almost everything as they will be jack of all trades but you need master of small caps!

At Ace Equity Investor, we look at small caps from a different lens to figure out potential multibaggers of the future. It may take a little more effort & time but it is worth it. If you are interested in joining our premier services, click here.

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