A percentage shot: investing in small caps

Investing in small companies is a lot about managing the percentages of winners and losers

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When I look back at what I have said and written over the years about investing in small-cap stocks, I see what looks like a dichotomy at first sight. Sometimes, I have said that smaller companies are high-risk investments, something that investors need to approach with caution. At other times, I have said that smaller companies are the only 'real' equity investments, in that they allow you to ride along the growth and success of a company to an extent that is simply not possible with larger companies.

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Although some of my readers have sometimes said that this is a contradiction, it actually isn't. In fact, these two views of small-cap investing are actually complementary. One wouldn't be possible without the other. It's often said that smaller companies are riskier because they are not as well-understood as bigger ones. Investors take this to mean that there is little research attention paid to them, so the truth about their prospects is not widely known. A company could be good, bad or ugly, but since the number of analysts who are studying it is just a few (or zero), no one knows the truth and this means high risk.

This is mostly true, but is actually only a small part of the story. Beyond the lack of attention, there is genuinely a very high degree of uncertainty about smaller companies' futures. 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 is precisely because of this uncertainty and this risk that smaller companies that turn out to be winners give outsized returns. The two aspects - high risk and outsized returns - are two sides of the same coin. What we have to do, as analysts and investors, is two different things.

One, understand that smaller companies are what is called a 'percentage shot' in cricket. These companies are hard to research and analyse and choose, but that does not mean that research and analysis is useless. It just means that we have to have the attitude that we have to manage the percentages and succeed at a higher percentage and fail at a lower percentage. Be prepared for the occasional bust and know precisely how to recognise it, when to acknowledge it to oneself and let go. Just as importantly, be really, really prepared for the gigantic winners and own them all the way till they become mid caps or even large caps.

This is exactly why I have sometimes called small-cap investing 'real investing'. If you invest only in large, well-understood and over analysed companies, you could do well with them and yet never really have a winner. I mean it's possible to invest for years in large caps and have returns that are kind of okay. Of course, okay is good, but you could just have done an SIP in a large-cap equity fund. That's a great option for a lot of savers, and Value Research is of course a champion of that approach, but that's not quite what many equity investors are looking for.

The other aspect of small-cap investing is never to lose sight of the larger picture of your investment portfolio and indeed of your entire financial asset base. Small-cap investing plays an important role and is hugely advantageous, but it's easy to get carried away. It's a percentage shot, and you must focus on improving the percentages.

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