Multibaggers could be dangerous? The good, bad and ugly about investing in smallcaps

Cyclicality in ownership:

Small cap stock ownership amongst investors continues to be cyclical. In a short span of less than 4 years, small cap investing has come a full circle. Back in 2013, investors uncertain of India’s economic growth, shunned equity and small caps were taboo. Valuation of small cap stocks was attractive with risk-reward being favourable. Investors ignored small caps for fear of the unknowns. Over the last 4 years, we have seen investors committing significant capital to Small and Micro cap stocks. The cycle has swung from lean to sufficient ownership. The total AUM of small and mid cap funds has increased from Rs31,000 cr to more than Rs114,000 cr over the last five years. This does not include PMS or AIFs that are raised from large investors.

Chronology in ownership exists in small cap stock investing. The cycle of ownership starts with promoters increasing their ownership. Promoter associates/ Smart Investors are the next to build ownership in them. Institutional investors step in later. Retail investors step in following smart monies. Smart monies exit when they believe earnings growth has been sufficiently discounted and incremental earnings growth may not lead to PE expansion. When institutional investor sells to retail investors, most stocks top out as supply in the stock expands leading to a path of long consolidation or long term correction in the stock. Since retail investors tend to enter towards the end of re-rating cycle, they become the last men holding the baby. As the stock does not deliver for extended period, retail investors tend to book losses as their patience wears out. This zero sum game has been repeating itself in all bull cycles.

Why are Small cap stocks fancied by Investors?

Uniquely differentiated/growing niches is one of the major reason to own small cap stocks. Small cap stocks, equated as multi-baggers, are synonymous for aggressive returns. At the same time, investing risk is also the highest. Spectacular returns in this segment are assumed in shorter period. Most investors tend to invest in small cap stocks expecting large returns from them. However, such returns involve a combination of valuation re-rating and earnings growth over longer periods. Rather than intent to own with a longer-term perspective, they feel booking profits in multiple small stocks periodically can be enriching. As the number of transactions go up, the probability of success starts to decline.

Ignorance about smaller companies

With over 1000 companies listed on the Indian bourses, comprehensive research on large number of companies is difficult to find. Most brokers cover top 250-300 stocks listed and traded frequently. Beyond these stocks, the trading volumes are not justifiable for maintaining detailed coverage. This leads to inefficiencies as information is sought sporadically with less investors tracking the companies on an ongoing basis. This leads to valuation at times becoming attractive providing opportunities in small and growing companies for long term ownership.

Ownership risk in Small Cap stocks

Most investors invest in equities across the market capitalisation spectrum. Small Cap stocks produce superlative returns in a cycle of growing domestic investor ownership. Domestic investors invest in small cap stocks as they believe these are tools to multiply capital. Successful investors in small cap stocks research the company in depth, understand business risks and invest at comfortable valuation which limits the downside potential and ride the re-rating cycle. Patient capital is the most distinguishing feature which sets them apart. Conviction to hold for extended periods before returns start to materialise is a critical success factor.

Most investors think about upside potential in small cap stocks without assessing risk to capital. They all start with posing to be long term investors. But when the downside starts to take shape, such investors lose conviction and panic to sell in desperation. The risk in ownership of small cap stocks continues to be liquidity risk. Markets are ruthless and any disappointment in earnings delivery versus investor expectation in a sufficiently owned stock can lead to significant value destruction. Needless to say, that in case of a larger and longer correction in the market, the impact cost of exiting a small cap stock can be quite high. This leads to serious loss of capital for an average investor who starts as a long term investor and exits in losses providing numerous justifications to do so. Expectation of fast bucks normally leads to faster erosion of capital.

Right approach to investing in Small cap companies:

We believe the right approach to investing in small cap stocks is invest only after a detailed due-diligence of the company and its business and have the capability to monitor the key assumptions for investing in such companies. Small cap stocks should not be treated as trading bets, as that’s the most riskiest strategy adopted by any investor since liquidity and investor interest changes drastically over the investment cycle.  Whether the promoters are keen on wealth creation of minority investors is the most critical factor to be understood by an investor. Most small cap company promoters are alleged to behave differently in their quest to create wealth for minority shareholders. Promoter ownership in small cap stocks needs be considerable justifying need of the management to create wealth for all shareholders. Companies with history of consistent communication with all investors at regular intervals have fared well since the investors can get to understand the business on an ongoing basis. Tracking consistency in promoter communication and execution strategy in a bull and bear phase, keeping an eye on changing ownership, Ability of the management to articulate its business strategy are few general aspects of monitoring an investee small cap stock.

In summary, we believe small cap stock investors is a high-risk investors’ game. Risk to capital being the highest, an investor needs to follow a disciplined process to identify and track such investments. Given the relatively high valuations in the small cap space, patient capital remains critical to success. Successful small cap investing can be akin to PE/VC investing, if growing companies spotted early, with 3-5 years of investment horizon, regular monitoring mechanism in place. Being astute and selective shall be the way forward in small cap stock investing.