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Follow the money

Why should you invest in small caps or why should you not?

Follow the money

There's this well-known story about the famous American bank robber Willie Sutton. Sutton was asked by a newspaper reporter why he robbed banks. He replied, "Because that's where the money is". What's the connection of this with small-cap investing? We'll come back to that at the end of this page.

As you can guess from the subject of our cover story of 'Wealth Insight' September 2022 issue, I will talk about small-cap investing on this page. What do you think I'm going to say? Old-timers reading 'Wealth Insight' and my columns for years will probably think they have a good idea, but I could easily prove them wrong.

How? Like a good debater in school or college, I can equally well argue for or against the motion. I can give you 100 per cent convincing reasons that small-cap investing is too risky for you to dabble in. Or, I can give you 100 per cent convincing reasons that small-cap investing is the best way for you to make outsized returns on equity investing.

Here's the interesting thing - both sets of arguments will be based on the same underlying facts about small-cap stocks. In essence, both will be correct arguments. How can that be, you'll wonder? The difference lies in you. It lies in whether your temperament suits small-cap investing and what kind of skills and research you bring to small-cap investing. Small-cap investing has higher risks and rewards, but you already knew that.

Look at it from another perspective, which is what I really believe. From the investor's point of view - from my point of view - there is no such thing as small-cap investing; there's only equity investing. Equity investing is a bottom-up activity, not a top-down one. By that, I mean I don't start by wanting to invest in small caps or large caps or this sector or that sector. I want to invest in good stocks at a good valuation that will make me good profits down the road.

Each stock is an independent judgement I make based on its business fundamentals, management, valuation and everything else that you know about. Then the chips fall where they may. Some of the ones you choose will be small, some large and some mid. Once you have chosen a stock, you may take a top-down view of its effect on your portfolio. For example, you may feel that you have too many small caps already, so you can't have any more. Fair enough.

However, the rewards of identifying a relatively less-known small cap and watching it come of age can be off the scale. That's why I say that small-cap investing is real equity investing. If an investor puts money only in large-cap companies that are well understood and over-analysed, then they could do well with them and never really have a winner. I mean, it's possible to invest for years in large caps, never do badly and still have returns that are kind of OK. The real growth opportunities are always at the lower end of the size spectrum.

One of the interesting things about small caps is that as the size of institutional investors in India has grown, their ability to invest meaningfully at the smaller end of the spectrum has reduced. If Rs 25 crore or Rs 50 crore is a big chunk of trade in a small company, then a Rs 10,000 crore fund cannot participate in that opportunity, no matter how much the fund manager likes that stock. Of course, that still leaves a lot of companies in funds' portfolios, as our 'Wealth Insight' September 2022 issue's cover story's data analysis shows. You'll find a close reading of the data tables useful in generating investment ideas.

So, coming back to Willie Sutton, who robbed banks because that's where the money was. Equity investors invest in small-cap companies because that's where the money is. That's what matters.

Suggested read: Everyone invests only in good stocks

This editorial appeared in Wealth Insight September 2022 issue. To read the cover story and other insightful analyses, columns and articles

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