Investing for outsized returns in small-caps
Authored by Siddhartha Bhaiya, Director & Fund Manager at Aequitas Investment Consultancy Private Limited
One of the greatest debates in the stock markets has always been about whether you should invest in small-cap Multi-baggers or stick to blue-chip stocks.
The answer is slightly more complex than that. If you have a long-term horizon and the mental makeup to digest market volatility for outsized returns, then clearly, small-caps are the place to invest for long-term wealth creation. However, if your primary goal is safety seconded by returns then you should stick to large caps.
So, before we begin talking about small-caps, let’s discuss the situations when you shouldn’t invest in small-caps
Short-term money – Never put short-term money in the stock markets, let alone small-caps. Your minimum timeframe inequities should be at least three years (and preferably longer). The longer your time horizon, the higher your probability of making money in the markets.
Belief in small-caps – S&P BSE Smallcap index has risen more than 300 per cent in the last 18 months but at the same time, small-caps can underperform for long periods of time (as they did from 2018-to 2020). The majority of the people sold out their small-caps as the stocks crashed 50-90 per cent during that period. If you don’t have the patience to ride out that underperformance, then you are better off investing elsewhere.
Volatility – While small-caps offer an opportunity to make multi-bagger returns, they are also inherently volatile. If you are going to panic at every 30 per cent drop in the stock price, then you should not be investing in small-caps. (Titan has had 12 corrections of 30 per cent -80 per cent in its 1,000x journey from small-cap to Large-Cap over the last 20 years).
Research process – Every company outside the top 250 is a small-cap and majority of those 6,000 odd companies are not investment grade. Small-cap investing requires high specialisation as most companies are under-researched and many of them have corporate governance concerns. Finding those high-potential companies with quality management from a diverse pool requires different skills. If you are going to invest on tips or hearsay rather than with an intensive and disciplined approach, then you shouldn’t be investing in small-caps.
When and how you should invest in small-caps?
Why – BSE Sensex was first launched in 1979 and only three stocks from the original constituents survive today. A lot of today’s large-caps started their journeys as small-caps. So, small-cap investing is essentially catching them young and holding them while they grow.
Regular investing – A lot of investors end up investing in small-caps during bull market frenzies. Small-caps as an asset class usually outperform the large-caps over long periods of time but one needs to be a regular investor in small-caps and not just when the going is good! At Aequitas, we have been one of the few fund houses that have stuck to small-caps philosophy even through the worst years of 2018-20.
Allocation – As an investor with a good understanding of risk, one should only allocate that portion of your capital that allows you to sleep well. You should only invest that proportion of your investible funds that you are willing to risk in the short-term for disproportionate gains in the long-term.
How to invest – Again, like any equity allocation, it is important to diversify yourself and seek professional advice. Unlike large-caps where one has the comfort of familiarity and visibility, investing in small-caps needs full-time focus to bridge the gap of information asymmetry and see through the façade of unethical management. Equity investing is like trying to swim in a flooded river while small-cap space is a flooded river with crocodiles swimming in it so you need a sturdy boat of a professional fund manager at your disposal.
Understand your fund manager- While investing in equities, the process and stock selection criteria are far more important than the returns (what’s even more important is whether the fund manager walks the talk). At Aequitas, we encourage our clients to understand our process and how we go about selecting our companies.
Lastly, since small-caps are by nature more volatile, one has to spend at least a five-year cycle in order to reap good returns from his investments.
At Aequitas, we believe that we have a reasonable understanding of finding out the next multi-baggers in small-caps space. Over the past nine years, we have successfully identified over 23 multi-baggers (stocks that have grown by 5X in our portfolio), which also includes a 100-bagger in Avanti Feeds.
We also cringe when people go and buy the next ‘deep value’ company, thinking it to be the next multi-bagger; lose money and then say bad things about small-caps on social media and do not come back to the markets.