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The Art of Investing in Small Cap stocks

May 15, 2015

In this issue:
» Is this a good time to invest in small cap stocks?
» 5 key lessons to boost your small cap stock returns
» Will poor monsoons impact Indian stock markets in 2015?
» ...and more!


00:00
Well, it is the 15th day of the month. A day that is keenly awaited by subscribers to Hidden Treasure - our small cap stock recommendation service.

The search for our next Hidden Treasure led me and my team to meet some prospective companies in Mumbai and New Delhi. After evaluating the companies on various parameters, we finally zeroed down on a multi-product manufacturer that caters to a wide range of industries including oral care, paints, pharmaceuticals, food and many others. What got us really interested about this company was some major expansion plans that it has chalked out for the current year, that are expected to give a big boost to its growth prospects in the coming times. By evening, our subscribers will know which company I am referring to and whether it is a compelling investment at the current levels.

Right now, there's something very critical that I want to discuss with all my readers. As you know, the Indian stock markets have been quite volatile of late. The optimism that we witnessed through 2014 and the early parts of 2015 now appears to have given way to fear and nervousness. There has been significant correction in the benchmark indices. The correction in the small and mid cap space has been even steeper.

As per an article in The Economic Times, there are 600-odd stocks in the small and mid cap space with market capitalisation between Rs 500 crore and Rs 10,000 crore. Of these, more than half of the companies have witnessed a correction between 30% and 80% from their year-highs.

I'm sure this must have prompted quite a many investors to consider the exit option. On the other hand, investors who were keenly looking forward to grab a chunk of the dream bull run are now deep in doubt.

Is it time to keep away from small cap stocks?

Having observed the markets over the years and the small cap space, in particular, there are a few things I would like to share about how investors should go about investing in small cap stocks.

There is never a good time to buy bad stocks

Investors are attracted to small cap stocks in their search for 'multibagger' investment opportunities. Let me tell you that the small cap space is indeed the right place to seek the big winners. But this does not mean that any small cap stock is going to make you rich. For every single money-multiplying small cap stock, there are dozens of value destroyers that can be a drab on your portfolio. You have to learn to separate the wheat from the chaff. If the business fundamentals of a company don't appear convincing enough, it is best to avoid it.

There is never a good time to buy expensive stocks

Investors, in general, have a tendency to invest when they see rising prices and optimism. And when the markets change course, even for a short while, they start looking the other way. This is classical pain avoidance tendency that causes investors to buy high and sell low. From my experience, I can bet that if the markets start rising again, investors will come back running to the markets. But let me tell you, nobody ever got rich buying expensive stocks. So the best time to buy is when there is mindless selling on the bourses.

Buy businesses, not sentiments

If you are relying on the so-called bull rally to make your millions, you could be heading for trouble. Sooner or later, investors will come back to their senses and dump companies that don't offer value. I have seen small caps skyrocketing in a matter of weeks. And I have seen them tumbling down in a matter of days. So if your small cap stock is not backed by a solid business, then it is something that you should be worried about.

The worst mistake - Portfolio misallocation

If you have been investing for a while, you know that there are going to be mistakes and misjudgments from time to time. Not all your investments are going to be rewarding. Some will be outright value destroyers and it would be best to exit them at the first sign of trouble. Some would be value traps. They wouldn't add much value to your portfolio. And then, there would be the winners. It is these stocks that would be your real wealth creators.

These things will appear crystal clear in hindsight. Until then, you would not know which one will be the hero and which one will be the zero. So the best way to go about investing in small cap stocks is to follow a portfolio approach. Adhere to strict allocation levels.

The last, little secret

Many investors have a tendency to sell their winners prematurely. This phenomenon is known as 'scalping'. At the same time, they hold on to the losers, waiting to 'recover' their cost price.

Do you know what really distinguishes the great investors from the rest? They have the ability to not only hold on to their winners, but also to add more as their conviction grows.

So, what you can do is when you find a prospective investment, don't invest the entire intended allocation all at once. Buy a partial amount first. Then track the business developments for a while. If you think the company is on shaky ground, you may want to exit the stock. But if your confidence about the company's prospects grows, keep making staggered investments when the prices are attractive. Over time, as your understanding of the company deepens even further and you still see value in the stock, you can increase your allocation to such solid companies.

What is the best way to invest in small cap stocks? Do you think the ongoing market correction could be a good time to accumulate solid small cap stocks? Let us know your comments or share your views in the Equitymaster Club.

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------------------------------


03:15
 Chart of the day
The impact of monsoon on Indian economy can hardly be overemphasized. Given our high dependence on monsoon rains, the agricultural sector is the most vulnerable to the changing rain patterns. But do monsoons impact the stock markets as well?

As per an article in Business Standard, in the last one decade, there is hardly enough correlation to suggest that monsoon can have much bearing on the market sentiments. In fact, as per the data, the BSE-Sensex returns were the highest in the year when the rainfall was most deficient with regards to long period average.

So will the markets be indifferent to the monsoons this time as well?

If the monsoons remain deficient this year, it will be the second year in row for a bad rainfall. And this can have severe implications for the economy. In the past, whenever market has offered double digit returns despite poor monsoons, the rise has been off a small base. However, markets currently are close to lifetime highs. Some reality check already seems to be happening if recent market movements are anything to go by. The earnings season has not been encouraging and FII interest also seems to be waning, at least for the moment. In the absence of any meaningful trigger, a poor monsoon season may hurt market sentiments even further.

Will Poor Monsoons Impact Stock Markets In 2015?

04:00
After a volatile start, the Indian stock markets managed to remain above the dotted line during the trading session. At the time of writing, the BSE-Sensex was up 112 points (+0.4%). The sectors leading the gains were healthcare and consumer durables. However, realty and metal stocks were trading in the red.

04:30
 Today's investing mantra
"We've really made the money out of high quality businesses. In some cases, we bought the whole business. And in some cases, we just bought a big block of stock. But when you analyze what happened, the big money's been made in the high quality businesses. And most of the other people who've made a lot of money have done so in high quality businesses." - Charlie Munger

This edition of The 5 Minute WrapUp is authored by Richa Agarwal.

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Equitymaster requests your view! Post a comment on "The Art of Investing in Small Cap stocks". Click here!

5 Responses to "The Art of Investing in Small Cap stocks"

aditya

Dec 21, 2015

Everything is fine brother asper as fundamental;vigorous; flawless research is concern . but tell me how much money a small investor can continuously invest over a period of years (10% of total equity investment as a statutory warning) and continue paying the membership premium to see the "Hidden Treasure" come true.
Aditya Mukherjee

Like 

sasanka Sekhar Nandi

Dec 21, 2015

Dear Sir, I am working in Private sector, I do not have time to go through your lessons and take out the actual answer form the details. What I take out, that only shows what you have recommended long back. I want now what "Stock" you are suggesting and what is the entry price, Exit Price and aprox Time frame. We do not have go through the detail story, thats why I subscribe this. Now can you tell me what stocks you have recommended recently and there still chance is there to make'ENTRY'. or for me it not use to subscribe this scheme. Thanking you. S. S. Nand, (Mob: 090881 30484)

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Frederick

May 19, 2015

first I would like to know your comment before I give my comment
Regards.
Frederick

Like 

Venkatesh

May 16, 2015

Is it profitable to invest in Lupin in the short term? What gains can I EXPECT in the next say 4 to 6 months

Like 

Vrao A mudigonda

May 16, 2015

Dear Sir
Indian people have given a clear mandate to Modi government
So he sould be allowed to fuction to fillfil the asperations of the people
He is a proven leader who his shown results earlier. The opposition is
actong funnily more so the Congress.They are blocking everything to hide
Their mistkes. Entire India knows what sort of politicians the mulayams lallus
sharads gowdas and mamatas. RSS is committed patroitic organisation from
where many BjP leaders have come. There is no point in suspectong them
And blocking their proposals
Oppostion is thonking blocking every thing is their duty. Bad for the cuntry.
Communist who has relevace in todays politics has becoming a great votary of
congress which is outrightly rejected by the country. Allow the government
To fuction to see the results. While entire world appreciating the congrss
is sulking here

Like (3)
  
Equitymaster requests your view! Post a comment on "The Art of Investing in Small Cap stocks". Click here!
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Equitymaster Agora Research Private Limited (hereinafter referred to as "Equitymaster"/"Company") was incorporated on October 25, 2007. Equitymaster is a joint venture between Quantum Information Services Private Limited (QIS) and Agora group.

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  2. Neither Equitymaster, it's Associates, Research Analyst or his/her relative have actual/beneficial ownership of one percent or more securities of the subject company at the end of the month immediately preceding the date of publication of the research report.
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Definitions of Terms Used:
  1. Buy recommendation: This means that the investor could consider buying the concerned stock at current market price keeping in mind the tenure and objective of the recommendation service.
  2. Hold recommendation: This means that the investor could consider holding on to the shares of the company until further update and not buy more of the stock at current market price.
  3. Buy at lower price: This means that the investor should wait for some correction in the market price so that the stock can be bought at more attractive valuations keeping in mind the tenure and the objective of the service.
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