Why Every Investor Must Have Small Caps in Their Portfolio - The 5 Minute WrapUp by Equitymaster
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Why Every Investor Must Have Small Caps in Their Portfolio

Mar 15, 2016
In this issue:
» Is corporate India dabbling in equities?
» Is this what's keeping the S&P 500 afloat?
» ...and more!
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Devanshu Sampat, Research analyst

Yesterday, my colleague Richa Agarwal released a report about a very exciting smallcap stock. Richa, as many readers will know, is the editor of Hidden Treasure, our exclusive smallcap recommendation service. She's dedicated to finding the biggest wealth creators for our subscribers. (Click here to gain access to Hidden Treasure).

I remember the first time I brought a smallcap stock. It was in my college days. Back then, I didn't know what 'smallcap' meant. Like most new investors, I brought a bunch of stocks that my eager broker suggested. Most were smallcaps, as I realised much later.

I did well. The stocks ran up (this was February 2006). I made 30% in a few weeks! Of course it was pure luck. But I thought I was a genius. It felt amazing. Little did I know how foolish I was.

In a bull market, most stocks generally go up. As they say, a rising tide lifts all boats. I didn't realise it then but I got a taste of what smallcaps can do for a portfolio. When markets go up, smallcaps tend to outperform. Any experienced investor will tell you that the reverse is also true. I shudder to think what would have happened if I had started investing in January 2008.

Thankfully, Hidden Treasure subscribers need not worry about timing the market. They are in safe hands. Presently, they can buy fourteen fundamentally solid smallcaps for the long-term. Seven of these are the highest rated 'Best Buys' that you can find in the smallcap universe right now.

This brings me to the moot point. Should all investors, even those new to the stock markets, buy smallcaps at all? We at Equitymaster, are very clear about our answer. Yes! To prove our point, we quote legendary investor, Warren Buffett:

"It's a huge structural advantage not to have a lot of money. I think I could make you 50 percent a year on $1 million. No, I know I could. I guarantee that.

The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in."

Think about it. Most people don't have the kind of money to invest that fund managers do. This is a good thing. It means you don't need to look for elephants. You can swat the attractive mosquitoes instead! Here's why every stock market investor should have the best quality smallcaps in their portfolio.

  • High growth potential: Imagine two companies in the same industry having similar solid fundamentals. Then, in the long-term, the company which grows faster will create more wealth. A good example: Amara Raja v/s Exide.
  • Valuation disconnect: Good quality smallcaps tend to significantly outperform largecaps in the long-term. But the key word is 'long-term'. Investors need to be patient with smallcaps. This is because of their lack of visibility. This can result in periods where the stocks' potential is not realised quickly. But when it is realised, the returns are huge. You can use this period of valuation disconnect to slowly accumulate such stocks.
  • Lack of institutional ownership: Remember Buffett's words? Institutional investors are busy hunting elephants. This is great news for the aam investor. If you can get in early, before the big guys, then big gains await you!
  • Liquidity: Many smallcaps are not heavily traded. This presents a good opportunity. A good quality smallcap, which is growing earnings over time, will attract attention. As the public becomes aware, demand for the stock goes up. When this happens many investors bid for a limited number of shares on offer. The result? You guessed it! The stock price rises rapidly.

If you believe that high quality smallcaps belong in your portfolio, then the next logical question is how do you find them? Smallcaps are risker than largecaps. How to mitigate the risks? How much exposure should you take in each small cap? We do this for a living. And I can assure you, the process is not easy.

But the good news is that you don't have to do the heavy lifting yourself. Richa's got you covered. Under her able stewardship, Hidden Treasure's been going great guns. Since its launch in February 2008, the service has delivered an audited success rate of 61%.

She has uncovered big winners like Page Industries, eClerx Services, NIIT Technologies, Balkrishna Industries, City Union Bank, Indoco Remedies, PI Industries, and many more! But you can't buy all these stocks at current prices. To find out which ones you can add to your portfolio right away, I recommend you get access to Hidden Treasure without delay!

Do you think every investor should have smallcap stocks in their portfolio? Let us know your comments or share your views in the Equitymaster Club.

02.40 Chart of the day

We have been writing about the dull capex cycle of India Inc. for a while now. With the same happening, investments of corporate India have been on the rise. As per CMIE data, mutual fund investments of the corporate sector stood at over Rs 6 trillion as of December 2015. This is higher by a fourth as compared to a year ago and up by 50% from eighteen months ago.

So, where have companies been investing their surplus funds?

Well...take a look at the chart below to get a better idea.

Where is India Inc. Parking its Surplus Funds?

Please note that 'L' is data as of September 2015. 'L-1' is a year before the latest data, and so on.

Investments in liquid / money market, debt and equity orients funds have always had a high share in total investments of corporate India. As of date, it stands at about 95% of total investments. However, within these three avenues, the debt oriented funds have always had the major share. After all, it is the safe and liquid option available to park the excess funds.

However, what is interesting (or worrisome - depends on how you see it) is how the proportion of investments towards equity oriented funds has risen in recent times. Currently, about 10% of the investments in mutual funds by the corporate sector is parked in equity oriented schemes.

This just goes on to show that even India Inc. has gotten swayed by the market momentum in the last year. What should investors make of this? Well...one way to look at it is that there are companies out there that are investing in stocks of other listed companies with their respective investors' capital. While they may or may not be good timers of the market or money managers, the key question is whether they should be dabbling in equity markets in the first place!

03:45

The S&P 500 index in the US has been hovering around its all-time high levels for a while now. While the index fell below the 1,900-mark last month, it moved back above the 2,000 levels recently.

As per newsmax.com, there has been 'rampant selling' by mutual funds and ETFs. They are believed to have pulled out as much as US$ 40 billion since the start of this year. Having said that, the current quarter is poised to see US$ 165 billion worth of buybacks within the constituents of the benchmark index. And the interesting bit is all of this is happening at a time when profits have been declining for the third straight quarter. This just gives a sense of how short term measures taken by companies is keeping the market afloat. What becomes essential is the sustainability of the earnings, which will be a key driver for markets going forward.

As per the website - 'Seven years of earnings growth has left chief executive officers flush with money to spend. Non-financial companies in the S&P 500 held more than US$900 billion of cash on their balance sheets at the end of 2015, up from US$870 billion a year earlier.'

While there is nothing wrong in managements using buybacks as a tool to return cash back to investors - at a time when investment opportunities are grim - the fact of the matter is that all of this coincides with the low interest rate regime in the US. In other words, companies have been borrowing cheap funds to buy back their stocks. After all, the S&P 500 companies have doled out US$ 2 trillion for repurchases since 2009!

The key question, thus, remains unanswered. For how long can such measures be sustained?

04.45

Indians markets were trading weak today. The BSE Sensex was trading lower by 0.75% or 190 points at the time of writing. Weakness was seen across the board with healthcare and FMCG stocks leading the pack of losers. Mid cap and small cap stocks were not in favour either with their respective indices trading lower by about 0.6% and 0.4% respectively.

4:50 Today's investing Mantra

"In any business, there are going to be all kinds of factors that happen next week, next month, next year, and so forth. But the really important thing is to be in the right business." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Devanshu Sampat (Research Analyst).

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Equitymaster requests your view! Post a comment on "Why Every Investor Must Have Small Caps in Their Portfolio". Click here!

2 Responses to "Why Every Investor Must Have Small Caps in Their Portfolio"

SANKARAN VENKATARAMAN

Jul 17, 2016

It will be a good idea if EM starts giving longterm average PE also of the recommending stocks.

SANKARAN VENKATARAMAN

Like 

Narendra

Mar 15, 2016

Hi

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Equitymaster requests your view! Post a comment on "Why Every Investor Must Have Small Caps in Their Portfolio". Click here!
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