Buy the story? Surely not

Anand Kumar

Some 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 statement that Minister Gadkari made about the de-dieselisation of the auto industry and some others about someone in a foreign brokerage being caught out for large-scale front-running. Basically, any news that was there was connected as the cause of the small-cap crash.

A day or so later it was all forgotten as normal programming was resumed. In fact, the entire episode was normal programming. 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 what's going on here.

Small-cap investing epitomises the essence of stock investing. While this sounds like a provocative assertion, perhaps more designed to stir you up than to be taken literally, it's something I strongly believe in. I'm not dismissing investments in major stocks like Infosys or Interglobe as anything less than genuine equity investing. They certainly are. However, to truly feel 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 come to the double-edged sword of small-caps - volatility. It makes them both high-risk and high-reward propositions. At a gut level, we all recognise that the fluctuating nature of stocks is what lends them their investment allure. While some stocks outperform others, and some might underperform 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, for instance; if you work hard at choosing the best bank fixed deposit, you are not going to generate a whole lot more wealth than if you choose at random. If I were writing about choosing the best risk-free deposits, no one would read a word of what I'm writing here.

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 rate than they will with larger companies.

The strange thing is that the volatility party of small-cap investing is actually over-feared. If you take the smallest serious interest in choosing your small-caps well, then you are more likely than not to get outsized returns. This has been my personal, as well as my professional experience in Value Research's equity analysis and recommendation activities. You have to approach small-cap investing with humility, you have to accept that you will make some mistakes, and you have to stick to the fundamental principles diligently. Understanding why you are investing, diversifying across companies and sectors, avoiding concentration, and buying at a good value, all become doubly important in small-caps. However, if we do that, then the risks are that much lower and the rewards are still outsized. However, this is 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 the stories are almost always more alluring than the reality, this boils down to 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 larger impact on the price. This is normal - this is what a small-cap investor signs up for. A 10 per cent drop in a large-cap is a huge thing - almost certainly indicative of some real issue. The same drop in a small-cap is not the same thing at all. This is something investors need to internalise.

Suggested watch: How to pick the hottest small-cap fund?