Wrong, stupid, and lucky

There are a few things that polarise equity investors more than small-cap stocks. This is completely understandable. On the equity markets, the greatest fortunes, as well as the worst misfortunes, seem to be produced by investing in smaller companies' stocks. Adding to the sorrow is the unfortunate fact that the greatest amount of regret and hand-wringing are also produced by NOT investing in smaller companies' stocks. Just the other day, while doing some background thinking for another newspaper column on the new digital IPOs, my mind went back to the Infosys IPO of 1993. The issue actually failed to find enough investors and had to be rescued by the merchant bankers. What a tsunami of regret that must have eventually produced amongst investors who chose to ignore this tiny Bangalore company which dabbled in some strange new business called software!

The important thing to understand is that this is not some strange event with a once-in-a-lifetime consequence. This is, as a matter of fact, the very heart of investing in smaller companies. After all, no one invests a little bit of money in a smaller company with the expectation that the company will remain small and the little bit of money will remain a little bit. Moreover, for a variety of reasons, investing in smaller companies is an activity uniquely suited to individual investors. It's inherently not an activity that is suitable for larger and institutional investors.

Last year, I read an essay by the American fund manager Ian Cassel on the spirit of investing in small stocks. As he put it very vividly, "There are a bunch of small stocks that will be 10x over the next five years that are waiting to be found. Institutions can't buy them. Only you can. The opportunity in small stocks (microcaps) exists because institutions can't own them until they go up. It is the small retail investor's duty to find them and collect the reward for doing so. When you find a winner, people will say you are wrong. When you hold a winner, people will say you are stupid. When you get rich from a winner, people will say you got lucky. You tell them you love being wrong, stupid, and lucky."

It sounds hyperbolic, some parts more than others. However, when you look at the track record of any investor who has kept their head down and carefully selected stocks for a decade or two, it's common to see evidence of this sequence of 'wrong, stupid, and lucky.' Of course, that's what others said - in reality, they were neither wrong nor stupid nor just lucky.

When I look back at what I have said and written over the years about investing in the stocks of smaller companies, I see what may appear to be a contradiction. Sometimes, I have said that smaller companies are riskier investments. At other times, I have said that smaller companies are the only 'real' equity investments, in that they allow you to ride along with the growth and success of a company to an extent that is simply not possible with larger companies. In reality, the two views are actually complementary in the sense that one wouldn't be possible without the other. Smaller companies are riskier because they are not as well-understood as bigger ones, there is little research done so the reality about their prospects is not widely known.

This is true. There is genuinely a very high degree of uncertainty about smaller companies' future. Many of them will never amount to anything. Many will fail and disappear. Even with the best of intentions, even with the best of research resources, even the best of analysts will make mistakes at a higher (much higher) rate than they will with larger companies.

That's all part of the game and is never going to change. However, it's precisely because of this uncertainty and this risk that smaller companies that turn out to be winners give outsize returns. The two aspects - high risk and outsize returns - are two sides of the same coin. The risk is high, the effort is high, and the rewards are high too.

Also read: Learning from IPOs