What do you do when the economy is slowing down and large businesses appear to be over-valued? One way to try to beat the downtrend is to invest in smallcaps. This is not easy and there are many arguments for, and against, small cap investing.
Small companies generally do not have much institutional coverage, nor is there large institutional stake in such concerns. This means a lack of information. Small businesses are also dependent on one or two individual promoters and a small number of personnel. Any incompetence, or dishonesty, on the part of promoters, or employees, can lead to a collapse.
This lack of information, and over-dependence on a few people, makes it hard to value small businesses with accuracy. There can be big price swings. There may be unpleasant surprises, if the management is unethical. Failure rates are high, since small businesses lack the resources to ride out downturns. Small cap investors also frequently run into problems of liquidity. During bearish periods, small cap trading volumes can dry up.
Those are possible downsides for small cap investors. On the upside, sales growth can be very high due to the low revenue base. A small cap can double revenues every two or three years, or even double revenues year-on-year during a boom. It can double profits every year. This is simply not possible for large companies with large bases. A small business may also be so niche in size that it grows even during a broad recession. All these mean that small caps can.
Let’s take a look at the NSE Small cap 250 Index, which tracks 250 smallcaps. The patterns may surprise you. Since January 2015, the index has returned an absolute 12.8 per cent (until Nov 22, 2019), which compounds out at a paltry 2.5 per cent over five years.
But this masks wild swings. In Jan 2015, the index was at 4,200. It hit a low of 3575 in Feb 2016 – a drawdown of 15 per cent. Then it zoomed till January 2018, when it peaked at over 7500. That’s 45 per cent compounded over two years, from the bottom to peak. Then it crashed to a low of 4,300 in Aug 2019. That is a drawdown of 43 per cent in 18 months. The index has gained 10 per cent in the last three months (until Nov 22, 2019).
Over this five year period, the big gains came after major corrections. The overall returns are poor because the segment as a whole has seen failures and losses since demonetisation. A smallcap investor would have to be prepared for a 25-35 per cent loss in any given year and he could hope for a 40-50 per cent gain in any given year as well. So, smallcap investing is not for the faint-hearted, even though it could be very rewarding.
The index return indicates that passive investing would be difficult and there is no practical way to capture index returns. Investors have to find returns by actively selecting outperforming businesses.
How does the investor pick through such a large mass of stocks and handle this sort of volatility? This would entail an enormous amount of time and a lot of independent research since, once again, there is little institutional coverage of many smallcaps. Most readers won’t have the time or the expertise to do this research.
Another way to pick up selective smallcap exposure is to look for mutual funds that specialise in smallcaps. There are quite a few possibilities. Most small cap funds have negative returns in 2018 and 2019 but the good ones have still returned over 14 per cent compounded in the last five years. This suggests that they have good enough research and selection ability.
The choices for broad smallcap exposure include Franklin India Smaller Companies Fund, the HDFC Small Cap Fund, L&T Emerging Businesses Fund and the SBI SmallCap Fund. These are all funds with long and impressive track records from good houses.
The advantage of going with mutual funds is of course, the hassle-free nature of the investment. The investor can set up an SIP and just forget about it. However, if you are interested in doing your own research, a good place to start would be a review of the portfolios of the funds mentioned above. The stocks they hold in common are likely to reward investors.
The author tracks economic, behavioural and corporate trends, hoping to gauge good avenues of returns