Small Caps: Big Risks, Big Returns

It is a good idea to bust some myths surrounding the small-cap space. Do they really suffer the most in a market down-turn? Can you be truly safe after investing in small caps? The answers to these questions can help determine the normal duration for which one should remain invested in small-cap companies to earn better profits.

There is a common perception in the investor fertility that small-cap companies are better suited to earn handsome returns in a very short-time period. It is true – small-cap companies do have an entrepreneurial approach of doing business and have the potential to offer robust appreciation. Further, because of their small size, these companies are able to respond quickly to change and capitalise on unfolding opportunities more readily than those with larger capitalisation. With a proven management track record and well-established products, small-cap companies definitely have the potential to move up the ladder. Additionally, small-cap companies are not usually tempted to engage in dilutive acquisitions that would decrease the company’s earnings per share in order to gain growth.

Another important factor while investing in good small-cap companies is that they could be prime targets for acquisition by cash-rich larger cap companies, and hence, often command a premium on their intrinsic value. Further, small-cap companies are definitely at the start-up phase of a full market cycle, which gives them immense room for substantial continued growth. The small-cap equity universe offers a broad selec-tion of companies, combining the aspects of growth, value, quality and liquidity.

However, it is also true that the small-cap stocks are more volatile than those with larger market capitalisation on account of reasons such as lower volumes and participation. Hence, in times of market correction, the smaller stocks are expected to feel severe pains. The companies are also difficult to track. But this does not mean that you should shun these stocks. Rather, as an investor, you should know and be assured of what you are buying. Also bear in mind that you should not jump into this equity universe just because everyone is suddenly talking about it.

To help our readers pick smartly from the small-cap universe, we present here a critical analysis of the returns generated by the companies in this group in different times over the past five years. As we have mentioned earlier, small-cap stocks are popular between investors who are looking for high returns in smaller time frame. Thus, we have looked at the small-cap equities universe, taking one-year time frames starting 2008.[PAGE BREAK]

There have been instances of stupendous returns to the tune of more than 70x capital appreciation on investments in a single year, as also evidence of capital erosion to the tune of 99 per cent of the investment. Interestingly, the capital erosion or appreciation have both been seen happening in a single year. This means that the companies which saw logarithmic movement in their prices have been experiencing dramatic changes in their fundamentals during the same period and have seen price stabilisation at those levels. Another trend seen was that if there was a considerable price movement in a stock on one side, it was unlikely to see one-side movement in the opposite direction in the next few years.

Long-term investors in equities will be interested to know that there have been instances in the past five years where this asset class has returned more than 100x the initial investment. Further, it has been seen that people who remained invested for the longer term, i.e. five years, earned maximum returns in most of the cases. Of course, there were some instances of small-cap companies giving logarithmic returns in smaller periods too (less than five years).

However, there are very few stocks which have moved up on the ladder and given consistent returns over a period of five years. In contrast, there are many small-cap stocks which have eroded investors’ capital completely (even up to 100 per cent) in the past five years. What differentiates the two is the quality of management, the business model and the scalability. Therefore, if you hold fundamentally strong stocks for a longer time frame, even small-cap companies can give consistent returns.

Furthermore, if you compare the cumulative and yearly returns given by the small-cap companies, you will see that most of the yearly top performers have not given such attractive returns over the longer term. This kind of inconsistent performance demonstrates the difficulties in stock picking from among small-cap equities, though, of course, it is not an impossible task.

In our view, those small-cap companies which offer the finest combination of the factors discussed above give investors a stronger potential for wealth creation. It is not hard to understand just how much more important it is to make smart and informed choices in this category of investments.

Click here to see the highest and lowest returns offered by small-cap companies (on a YoY and Cumulative basis)