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Small cap stocks? Better returns
Devangshu Datta
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November 06, 2007

About a decade ago, I had the opportunity to chat to a well-known marketeer, who had been associated with Hindustan Levers (as it then was) for a large part of his career. The circumstances were relaxed and off-the-record.

I couldn't resist one pointed question: "How did HLL [Get Quote] pass up the opportunity Nirma exploited? After all, Levers pretty much owned the soap/detergents market of the 1980s. Surely it understood the potential in penetrating lower-income segments?"

His answer was illuminating (though I have no idea whether it was true!). He said, yes of course, HLL knew. But it reckoned the market too small to be worth the effort. The lower-income segment was then reckoned to be about Rs 100 crore (Rs 1 billion). A Rs 5,000 crore (Rs 50 billion) company spurned it after weighing the costs of either diluting existing brands or creating new low-cost brands.

Karsanbhai on the other hand thought a Rs 100 crore market was manna from heaven since he came from the other end of the spectrum. He had started by literally cooking up products in his backyard and delivering to the local bais on his bicycle. By the time HLL focused on the low-end market, Nirma was entrenched.

Similar problems of scale crop up in the stock market. A fund manager handling asset under management (AUMs) in the Rs 1,000 crore range or more doesn't waste time researching small stocks. May be a small stock will produce 200 per cent returns - so what? It can absorb a maximum of say, Rs 1 crore (Rs 10 million) and the Rs 2 crore (Rs 20 million) return will scarcely add to the NAV of a major scheme.

That's why there's little institutional focus on this end of the market. Few portfolio managers will examine small companies; most stick to copy cat emulation of the big funds' portfolios. As a result of this neglect, there's a negative feedback loop.

Information-gathering about a small company takes more effort than with a big concern. The lack of institutional focus allows managements to indulge easily in shady practices, if they so desire. The free float is held by retail investors who are more easily swayed by rumours and more vulnerable to operator-activity. Prices can swing alarmingly with little in the way of apparent triggers. 

Fundamentally too, small businesses are at greater risk. They are often under-capitalised and desperately dependent on one big client or one line of business. They can get wiped out if the cycle turns against them or the management makes one bad decision.

But the smaller the business, the better the potential for growth. If you're a retail investor, you could log a 10-bagger and set yourself up for life before the funds have even registered the presence of the company.

Here's the paradox. A fund has the resources to check on the fundamentals of small, obscure businesses. It has the clout to meet management and assess competence and probity. A retail investor doesn't have the resources or the clout. But in terms of financial planning, it doesn't make sense for a fund to look at small caps whereas these are ideal investment vehicles for retail investors. 

Small caps returns are often completely out of synch with big stocks. In fact, they are often out of synch with small cap indices! The BSE Smallcap Index has little correlation with the Sensex and even the BSE Smallcaps tracks stocks that are relatively large.

How do you judge the value of a small cap? Much the same way as you would judge the value of a bigger business but the information at your disposal will be less. If you do decide to go with a small cap make sure it's a business you understand personally and if possible, one that's local. If you can locate people who work for or with a business, they often come through with useful intelligence.

A small stock player must make very fine-tuned calls on the quality of management and also avoid being sucked in by price-manipulation. The risks are high. In bear markets, liquidity in small stocks disappears and there is often no exit option. So if you enter a small stock, you should be there for the long-term.

Against that, the chance of finding 5-baggers or even 10-baggers is much, much higher because of the base effect. If you choose to be an active investor, this is perhaps the most rewarding segment to focus on.

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