Don't fear the volatility: How to choose the right small-cap stock for low risk and high returns The strange thing is that volatility in small-cap investing is over-feared. Even if you take a little interest in choosing your small caps well, you are more likely than not to get outsized returns
Dhirendra Kumar
CEO, Value Research
A few days ago, small-cap equity investing suffered one of its periodic hiccups. Small caps fell sharply and then regained most of the ground over a couple of days. Why? No one knows, but as is the norm nowadays, there were plenty of people who pretended to know. There were theories about a Union minister’s statement on the de-dieselisation of the auto industry, and about someone in a foreign brokerage being caught for large-scale frontrunning. So, just about any piece of news was linked to it and considered as the cause for the small-cap crash. A day or so later, all was forgotten as normal functioning resumed. In fact, the entire episode was normal. For those complaining about small-cap volatility, this is normal. We can go into the reasons later, but this is actually desirable. Let’s take an unbiased view of the developments.
Small-cap investing epitomises the essence of stock investing. While this sounds like a provocative assertion, designed more to cause a stir than to be taken literally, it’s something I believe in. I’m not dismissing picking major stocks like Infosys or Innterglobe as less than genuine equity investing. However, to experience the journey of owning and growing a business, one should invest in a small-cap stock and watch its evolution into a mid cap and, eventually, a large business. Let’s consider the double-edged sword of small caps —volatility. It makes these a high risk, high-reward proposition.
At an instinctive level, we all recognise that the fluctuation in stocks is what adds to their allure. While some stocks may outperform and others might underperform compared to their past, this unpredictable nature is what renders them both risky and potentially lucrative. The real reward lies in savvy investing, especially in stocks poised for significant future growth. It’s essential to acknowledge the intrinsic link between risk and returns. We know that exceptional returns aren’t generated from risk-free investment choices. Take fixed deposits. If you work hard at choosing the best bank fixed deposit, you are not going to generate significantly more wealth than if you were to pick at random. If I were writing about choosing the best risk-free deposits, no one would read a word of it.
There is genuinely a very high degree of uncertainty about smaller companies’ future. Many of these will never amount to anything. Many will fail and disappear. Even with the best of intentions and research resources, the best of analysts will make mistakes at a higher rate than they will with larger companies. The strange thing is that volatility in small cap investing is over-feared. Even if you take a little interest in choosing your small caps well, you are more likely than not to get outsized returns. This has been my personal and professional experience in Value Research’s equity analysis and recommendation activities. You have to approach small-cap investing with humility, accept that you will make some mistakes, and stick to fundamental principles diligently. Understanding why you are investing, diversifying across companies and sectors, avoiding concentration, and buying at a good value become doubly important in small caps. If we do that, risks are that much lower and rewards are still outsized.
However, this not the common way that investors approach small caps. The problem is that most investors approach small caps with an attitude that eventually boils down to ‘buy the story, sell the reality’. Since stories are almost always more alluring than reality, this turns out to be the exact opposite of what one should be doing; it’s just a different way of buying high and selling low. This does not mean fearing volatility. Small caps tend to have high promoter stakes and low floating stocks. The exact same events will create a bigger impact on the price. This is normal. This is what a small-cap investor signs up for. A 10% drop in a large-cap is a huge development, certainly indicative of some real issue. A similar drop in a small cap does not imply the same thing. This is something that the investors need to internalise.
The Author is CEO, VALUE RESEARCH
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(Disclaimer: The opinions expressed in this column are that of the writer. The facts and opinions expressed here do not reflect the views of www.economictimes.com.)
This story originally appeared on: India Times - Author:Faqs of Insurances
