Small Caps: Diamonds in the Rough

Small Cap investing is associated with high returns and high risks. However, despite a history of showing handsome returns, small caps are avoided by most of the investors and are treated as the step child of investing. Although there are many reasons why investors avoid small caps, the one sighted most often is the “riskiness” of small caps and the quantification of this risk has always been the volatility of their returns.

On the risk aspect first - Howard Marks, of Oak Tree Capital, in his memos and books has argued why volatility is often incorrectly used as the primary measure of risk. He states that it is because of the ease of quantification and usability in calculations which has made it the “academician’s choice for defining and measuring risk”. In reality, it is the permanent loss of capital that the investor should fear most and not the temporary market fluctuations which volatility captures, he argues. Yes, the volatility of small caps has historically been high, however that doesn’t necessarily mean that they are the riskiest.

The way one can avoid the real risk, i.e. the permanent loss of capital, is by following an investment strategy that enables one to identify high quality companies, then paying the right price in terms of valuation and finally through diversification of the portfolio to minimize impact of unforeseen accidents that may occur.

Hence, the riskiness of a portfolio or investment is better managed if volatility is thought of as one of the variables and not the only variable to measure risk.

On the returns aspect, the small cap category of mutual funds has been the best performing investment category over the long term – as exhibited by the table* below:

A key point to note here is that this outperformance is despite the recent sharp relative underperformance vis-à-vis the large caps. The large cap index year to date is flat, while small cap index is down almost 35 per cent over the same period.

A key point to note here is that this outperformance is despite the recent sharp relative underperformance vis-à-vis the large caps. The large cap index year to date is flat, while small cap index is down almost 35 per cent over the same period.

An important aspect as regards the higher returns is that these stocks remain out of the spotlight until they attain a noteworthy size in terms of revenues and profits. Hence, institutional ownership is generally low. Secondly, the inefficiencies in price discovery mean a higher potential for better returns, as typically lesser number of sell side analysts track these companies (4 analysts per company in case of small caps vs. 33 in case of large caps). 

Last but not the least, when investing in small caps one should understand that there is a high probability of finding a lot of diamonds in the rough. Over the last five years, almost a fourth of all small cap stocks have become Five-baggers (i.e. giving 500 per cent plus returns over 5 years)*. Although this proportion of high performers may change in the future, we expect small caps to continue to shine and sparkle like diamonds over the long term.

*Source: Value research as on October 31, 2018

The author is Senior Fund Manager with BOI AXA Mutual Fund.