Hope Investing in Small cap stocks!

Often in Bull markets, Small cap stocks send retail investor into frenzy. Steep gains in matter of months lure them into allocating more and more funds on their next bet. Lets say, a newbie starts with 10,000 in a stock on friend’s advice and the stock doubles. He regrets betting just 10,000, next time he makes up his mind to bet more. Next 2-3 occasions tend to be equally rewarding. Then one fine day when he bets 10,00,000, a big chunk of his savings, the markets dooms and most of those stocks never seem to recover for years. This is typically happens near new all time highs. He gives up on equity investing calling it a gamble and equity since then becomes something close to social stigma.

The joy of instant gratification is what we seek. However, investing is more about delayed gratification. You put away small sums now, and compounding would do its magic to get you a big corpus at the end of your investing horizon. But the desire to earn in immediate future lures people. Lot of research has gone into why people choose near term small benefit over asymmetrical large delayed benefits. It must be more to do human nature to shun uncertainty of future.

Small cap companies can grow their profits very fast for short duration and since they are illiquid the price movements are also steep. Overnight multibagger stories are not uncommon in such stocks during bull markets. Investors with no prior experience tend to get astonished by near term performance. More experienced investors would know that, the bad cycle is equally or more brutal than upcycle. There is absolutely no hope whether a small cap company would even recover from a bad cycle. This company won’t face a bad quarter in bad times but declare complete bankruptcy. No wonder that BSE Small Cap index just broke even last week since its peak index value in Jan’2008 while BSE Sensex is up atleast 50% from its previous peak. A few would disagree saying that handpicked stocks would have performed better so index figures are misleading. The point they are missing is because of survivorship bias.

“Survivorship bias, or survival bias, is the logical error of concentrating on the people or things that “survived” some process and inadvertently overlooking those that did not because of their lack of visibility.”

Check how many of these top 20 small stocks still exist?

List is from 2007

Company 10Yrs Return
Unitech 34196%
Matrix Laboratories 29910%
Phoenix Mills 28935%
Donear Industries 28533%
Vimta Labs 27799%
Pantaloon Retail 20412%
Infosys Technologies 19583%
Mercator Lines 19545%
Wipro 17319%
Patel Engineering 17075%
Satyam Computers 16942%
Financial Technologies 16342%
Havells India 15928%
Lakshmi Energy & Foods 12586%
Arrow Webtex 12281%
Panoramic Universal 11587%
Prime Prop. Devp. Corpn. 11518%
Aban Offshore 10592%
Amtek Auto 10590%
Jetking Infotrain 9557%

Stock performance seems obvious after it did perform well. However, the future never looks bright at the time of purchase. For Example, Bajaj Finance/Finserv may seem obvious now but it was in its worst situation during 2008 financial crisis. Symphony was a Bankrupt company! Eicher Motors was in its bad phase and the stock traded below cash on its book; later people bought the stock due to value creation from its Joint Venture with Volvo which has still not fructified (Royal Enfield was a sheer luck for that investor!). Bharat Financial Inclusion, erstwhile SKS Microfinance, was almost bankrupt.

There were atleast 100 other small cap companies with ROE of more than 15% and P/E ratio less than 15x. Given these situations, we ask how many of you would have bought one of the above mentioned stocks? If yes, had you put 10% of portfolio in them? We suspect if your answer is yes.

We put big question mark on current small cap darlings whether they will survive next slowdown in economy or even its own industry slowdown. In recent past, most gains have come from P/E ratio expanding from 7X EPS to 15-20XEPS. Profits are rising due to lower raw material prices. While all of this is behind us, it will be interesting to see which set of companies chart sustainable earnings growth to continue enjoying such steep valuations. We do agree that there will be 5% of small cap companies which will still become future multibaggers from here but only concern is which 5%? And we are not sure whether we are willing to invest even 5% of our portfolio in them.

Everyone just “hopes” to have the hottest stock in their portfolio; while we choose to walk in the opposite direction. We will invest in stocks when there is high certainty of survival and narrow range of future outcomes. In addition to that we will have conviction to invest heavily, say 5-10% of portfolio in those stocks.

While most Indians have 80% savings in Real Estate and Gold, our method gives you more confidence to put more money in equities than illiquid physical assets which earns no better lifestyle. Just 13-15% return on 50% of your networth can do wonders rather than 30% returns on just 10% networth in equity. We believe that our strategy far outweighs more prominent strategy of finding the next multibagger.

Happy Investing!

 

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