Small-cap investing strategy

Always keep in mind that it can rise or fall by 20-40 per cent in a given year

After a long period of bearishness, there’s been a revival of investor interest in small-cap stocks. Many investors are re-entering that segment. There are many arguments for, and against, small-cap exposure. 

Small-cap investing is one of the most difficult and potentially rewarding styles. It’s hard because small companies don’t have track records and there is usually little information. They are also very dependent on one or two individuals for growth. There usually isn’t large institutional coverage, or institutional stakes. 

This means wild swings in price and unpleasant surprises when you discover that the management isn’t as ethical as it should be. Nobody knows how to value a new business with much accuracy so opinions on fair-price in terms of earnings discounts vary a lot as well. Failure rates for small companies is also very high since they tend to lack the reserves and resources to ride out a bad cycle. Two quarters of losses can wipe out a small business. 

Balanced against that, sales growth can be very high in percentage terms simply due to the low revenue base. It is possible for a small cap to double revenues every two or three years, or even on occasion, to double revenues every year. It is entirely possible for a small cap to double profits every year. You can get several years of triple-digit earnings growth if you are lucky. This is simply not possible for a large company with large top lines. 

Small caps can also have a certain degree of immunity to recession. A large company may have the resources to ride out recessions but they do suffer. A small business may be so niche in size that it continues to grow even during a serious recession. 

Small-cap investors frequently run into several practical problems. One is that trading in small caps tends to freeze during bearish periods. Volumes can dry up completely. It may be impossible to cut your losses and exit. It may also be very difficult to acquire positions in beaten-down small caps because there is poor volume. 

It may be difficult to judge the reasonable position size for individual stocks. It is also hard to decide what level of overall small-cap exposure suits you. What is a reasonable ratio of small caps to midcaps/large caps in an equity portfolio? 

If small-cap exposure is very low in proportion to the size of the entire portfolio, the hoped- for high growth there won’t make a material difference to overall returns. If small cap are a very large proportion on the other hand, the entire portfolio will have high volatility and there could be big drawdowns in bear markets. This is an individual decision, of course, and it depends on your risk appetite. But it may be worth it to consider this is in some detail. 

Let’s take a look at the NSE small-cap 250 Index. You may be surprised at the patterns and it might help to inform decisions. Since January 2015, the index has returned an absolute 14.5 per cent, which compounds out at a paltry 2.9 per cent. This masks wild swings. 

In January 2015, the index was at 4,200. It hit a low of 3,575 in Feb 2016 — a drawdown of 15 per cent. Then it zoomed till January 2018, when it peaked at over 7,500. That’s a return of 45 per cent compounded over two years, from bottom to peak. Then it crashed to a low of 4,300 in August 2019. That’s a drawdown of 43 per cent in 18 months. It has gained 12 per cent in the last month. 

That’s a five-year period. The big gains came when investors entered after a major correction. The overall returns are poor, however, because the segment as a whole has seen plenty of failures and losses during the recessive period since demonetisation. 

A small-cap investor would have to be prepared for a 25-35 per cent loss in any given year. He could hope for a 40-50 per cent gain in any given year as well. There was a major correction that ended just a month ago. So the timing to increase exposure in small caps seems reasonable. If this is a false dawn however, and the market collapses again, this segment will also see the most damage. Keep all those considerations in mind if you decide to get back into small caps.