How to Make Smart Small-Cap Bets

There is a fundamental reason why small-cap stocks should comprise a part of your equity portfolio. Small-sized companies that get their strategies right can grow at a very fast pace. Their faster earnings growth translates into rapid appreciation in stock price. When the same companies grow larger, growth slows down or plateaus (due to the larger base effect, saturation of markets, and so on). In India there is an additional factor at play. Says Pune-based financial planner Veer Sardesai: “In India small-cap stocks are not as closely tracked as large-cap stocks, hence greater pricing inefficiencies exist in this space. You can sometimes get these stocks at a high discount to their intrinsic value.” Empirical evidence in favour of small-caps Academic studies in the US market have shown that small-cap stocks outperform large-cap stocks over the long term. US-based researchers Eugene Fama and Kenneth French examined the long-term performance of value stocks versus growth stocks. They took all the stocks on the New York Stock Exchange, the American Stock Exchange, and the Nasdaq for which they could get reliable data and divided them into 10 groups based on their price to book value ratio. Group one consisted of the most extreme value stocks while group 10 consisted of the most extreme growth stocks. The researchers analysed data over a 27-year period that straddled both bull and bear markets. They found that value stocks significantly outperformed growth stocks. On an average, the price of the most extreme value stocks - those in group one - went up seven times over 10 years, which amounted to a 21 per cent annual rate of return. The most extreme growth stocks - those in group 10 - only about doubled in price in 10 years, which amounted to a rather disappointing 8 per cent rate of return. Their conclusion: over the long term, value stocks tend to outperform growth stocks. What is more relevant for our purpose is that Fama and French repeated the same exercise to evaluate the impact of size (

This article was originally published on July 26, 2010.