Over a long period of time small cap stocks outperform the index by substantial margin. Rolf Banz in his seminal paper “The relationship between return and market value of Common Stocks” found that small stocks systematically outperform large stocks, even after adjusting for risk, defined in terms of beta. A study of groups of stocks divided on the basis of market capitalization through 1926-2001 shows that whereas largest market cap stocks gave a return of 9.6% cagr, the smallest stocks gave a return of 14.03% in the same period. James P. Oshaughnessy found that small stocks outperform the larger peers by a margin of 3.12 annually. The investment portfolio of Rakesh Jhunjhunwala’s shows that there is no “index stock” in his portfolio. Small stocks have some great qualities which may make it a sound investment. An investor needs to understand those characteristics to gain from this investment option.
A smaller company has various benefits which larger company lacks. Firstly, due to sheer small size it can easily grow its sales by a decent percentage point every year. Many a times growth comes automatically just be starting to serve new geographical area and wider acceptance of the product. Further, with increasing sales, it automatically gets the positive economies of scale, leading to better margin and better profitability. Further, these companies are generally led by first generation entrepreneurs, who have taken a company from scratch to sales of 50-100 crores, which is a feat in itself. It gives sufficient confidence in capability of the management.
As smaller company’s stocks are generally illiquid and there is no institutional interest, its stock price tends to more inefficiently determined. It gives opportunity to an individual investor to do its research and invest in such stocks. An individual investor who plans to buy a few hundred or a few thousand shares of some company can buy easily even if only a few thousands stocks are traded on a daily basis. Further lack of institutional interest ensures that there are few (and in many cases none) research reports on these companies, information are not easily available about these companies provides opportunity. Research in such companies is more likely to result in gems finding as few people are searching anything there. Researching in larger companies, which are researched by numerous institutions with vast resources, are not likely to result into gems finding; if there are any gems, institutions will find it much earlier than any individual investor. Larger stocks are likely to be much more efficiently priced and attempt to beat the market in that space is more likely to fail.
However the smaller stocks face unique problems. The first thing we need to understand is high mortality rate of small companies. In difficult economic environments, large companies survive on strength of its balance sheet, brand power and borrowing ability whereas smaller companies find it difficult to survive. Thus it is extremely necessary to examine the survivability of smaller companies before any investment can be attempted in those companies. Low debt level and positive cash flow from the operating activities are two criteria, which ensure that the company has better chance of survival in difficult economic environment.
High mortality rate of smaller companies necessarily requires diversification. In whatever way a small cap stock is purchased, a few will not survive. Therefore, it is necessary that a group of stocks should be purchased. I think a typical portfolio of 10 to 30 stocks will serve the purpose of diversification for a portfolio of upto 100 crores. In larger portfolio one may need hundreds of stock, Peter Lynch had around 1500 stocks in his Magellan Fund portfolio.
If a smaller company survives and grows at a decent pace for a few years it can be an excellent investment. As the company grows in size, it gets the benefit of “economies of scale” and generally enjoys better profitability with increasing size. Better profitability results in better growth of earning per share. Once these stocks attain a size, institutional interests are attracted resulting is rerating of shares.
Chances of balance sheet cooking are much higher in smaller companies. Thus effort should be made to avoid stocks where there is a possibility of balance sheet cooking. If a smaller company is growing without much additional financing, either through debt or equity dilution, balance sheet cooking is likely to be absent. Further a strong cash flow from operating activities is also act as an insurance against such practices. If the company is dividend paying, and increasing dividend every year, there are fair chances that reported balance sheet is true.
The other aspect is competitive advantage of the company. It will be very difficult to find very strong competitive advantage in small and micro cap stocks. In my view value addition done by the company can be a good yardstick of competitive advantage of the company. If the value addition done by the company is more that 50% of the net sales, or alternatively cost of raw materials is less than 50% of the net sales, it can be inferred that the company has some kind of advantage.
Smaller stocks are more volatile than the market index. Generally it falls harder in a falling market. Thus these stocks should be brought in relatively pessimistic times. Further higher volatility in these stocks provides excellent opportunity to but these stocks when the stock market has corrected substantially from the recent peak. However, investor must not try to catch the bottom in such stocks, which is as good as impossible. Many a times buying these stocks shall involve “catching a falling knife”, which ought to be attempted by small stocks investors.
The benefits of such stocks arise mainly because these stocks are not much researched by institutional investors. As not much research is available in such stocks, very few brokers have any recommendations of these stocks; investment in these stocks necessarily involves self-research. Without self research it is not possible to get benefit from these stocks. But, path to riches were never easy, and it will be easy even through investment in small stocks. It will involve self research and continuous monitoring of company’s performance on quarterly basis.
Investing in these stocks required a very long term investment horizon, in my view at least 5 years. It must not be attempted for shorter time horizon as small stocks can underperform the market severely in the short term.
