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The Small-Cap Advantage

Just a handful of smaller companies make it big, countless others fall by the wayside, or toil forever in relative obscurity

 

 

This is the editorial accompanying  the Wealth Insight magazine's cover story (issue December, 2009) that highlighted investment possibilities in this most-risky stock market space.

From an investors’ perspective, fundamentally, size is one of the most important characteristics of a company. Whether it is for formulating investment strategies, launching mutual funds or creating market indices, grouping companies by size is the most common way of classifying stocks. And with good reason. Smaller companies are inherently different from larger ones. Like everything else about stocks, these differences can be divided into trading differences and investing differences; or, for want of better terms, technical differences and fundamental differences.

From a trading perspective, the smaller a company, the more volatile it is. Such stocks invariably have a high beta — they rise more than the markets when the markets rise and fall more when they plunge. Their shallow volumes and sparse floating stock means that prices are easy to influence, making them simple targets for price manipulation.

However, all that is a concern of the momentum trader, who likes to move in and out of hot stocks. Small-cap investing is quite a different type of activity. Contrary to small-cap trading, small-cap investing is all about the long-term. There’s only one way of being a successful small-cap investor. You have to identify companies that will grow and keep on growing far into the future and invest in them. After that comes the really hard part — staying with the stock through thick and thin, till it eventually becomes a large-cap.

This is a very different kind of activity from the one that involves identifying business cycles and how large, well-known companies will move through those cycles. In many ways, this is stock investing at its purest. It is also at its most rewarding. You can identify an opportunity with a large-cap stock and, if it turns out to be a perfect call, then you could get perhaps, 20 per cent more than the general market. However, it’s only with a smaller company that you could identify a great unnoticed business at a price of Rs 50 and five years later have it at Rs 500. It’s not as if this sort of a thing doesn’t happen. You could have bought Titan at Rs 77 in 2003 and watched it reach Rs 1,600 in 2007. Or, you could have bought Infosys at Rs 300 (bonus-adjusted) in 2001 and watched it go to Rs 2,500 in 2009. There are countless other examples too.

I personally feel that this is rewarding at two levels. The financial gains are enormous, but as an investor it is emotionally very rewarding as well. It’s in this kind of a case, when you see a business grow from an unknown to a nationally, or a globally, recognized name that a share-owner feels like a co-owner of a business. He feels that he’s part of a larger story.

However, let’s not get too carried away. Selecting stocks like this is difficult. While the rewards of making good choices are high, the risks are high too. Just a handful of smaller companies make it big, countless others fall by the wayside, or toil forever in relative obscurity.

It takes commitment and care to select such companies. In our cover story (10 Small-Cap Bets), we’ve got a selection of small-caps that have taken the fancy of institutional investors in recent times. Whether you invest in these or not, it is an interesting exercise to read about these stocks and see the logic that goes into selecting them. I hope that reading these stories will help you look at small-caps as something more than just momentum opportunities.

Also Read:

Cover Story: 10 Small-Cap Bets
1.  3i Infotech
2.  Apollo tyres
3.  Eicher Motors 
4.  Everonn Education
5.  Gateway Distriparks
6.  McLeod Russel India
7.  NIIT Technologies
8.  Polaris Software Lab
9.  Sterlite Technologies
10. Vijaya Bank

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