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The Small Secret to Smallcap Investing

Oct 16, 2015

In this issue:
» Risk aversion vs. Loss aversion
» The economic threat from bank frauds
» Engineering exports antithesis to Megatrend?
» ....and more!

00:00
Imagine tomorrow morning you see a profit of Rs 5,000 in your portfolio.

But later you realise that you have lost your wallet carrying Rs 5,000.

What thoughts will you go to sleep with - the satisfaction of having earned 5,000 or the remorse of having lost 5,000?

I bet you will rue the lost money for days and do your best to recover that loss. The fact that, having gained 5,000, you are neither better nor worse off won't make you feel better. This is because most of us have been trained to treat gains and losses very differently.

This is why investors aren't jubilant about small profits, but a string of small losses can cause panic. If you were to ask Buffett, he would explain this as the difference between 'risk' and 'loss' aversion.

Just like insurance businesses account for possibility of small losses in return for tremendous long-term gains, investors need to recognise that small losses are part of the deal.

This is especially true in small cap investing.

Here you seek to buy small businesses, typically with few products and limited moats. The possibility of growth, though evident, is not certain. And the business' ability to overcome various challenges is untested.

Stocks like these typically slump with few quarters of unacceptable performance. Investors turn loss averse.

'It's already down 30%. What if it loses another 20%?' they fret. The fear of losing money is so strong that they can't see that the downside has diminished while the up side has gone up. Such investors are loss averse.

But smart investors would rather be risk averse than loss averse.

Of course, it is important to know if the business is fundamentally sound and backed by a capable management. Then all we must do is determine if the stock is available at a good discount to its intrinsic value. If indeed the fundamentals and valuations are solid, it is a brilliant opportunity for the risk averse investor. The margin of safety will minimise the downside risk. Whereas the upside is all profit.

When investing in small cap stocks, you have to be aware that you are courting the risk of loss. Not just loss of profits but in some cases the loss of capital as well. But the solution isn't to sell or avoid every small cap stock that is going down. Instead, if you take the pains to develop risk aversion rather than succumb to loss aversion, you won't lose sleep over small, temporary losses.

My colleague, Richa Agarwal, Managing Editor of Hidden Treasure, never fails to remind subscribers to limit their exposure to small caps. She recommends to never increase exposure to a stock beyond 3-5% of the portfolio. That is just one of her way to practise risk aversion. She also insists on great track records when considering investing in businesses facing temporary headwinds.

The next time you're hesitant about a solid small cap company, ask yourself if you are being loss averse or risk averse. Embracing risk aversion is a small but central secret to successful small cap investing.

Do you think getting risk averse instead of loss averse will improve your chances of successfully investing in smallcaps? Let us know your comments or share your views in the Equitymaster Club.

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02:40
 Chart of the day
It is no secret that we endorse RBI as the kind of central bank that every economy should aspire to have. The manner in which the present and past governors of the central bank have averted one economic crisis after the other has left everyone in awe. But if we have to point out one grave error that the RBI has been neglecting for long, it is regulating the quality of management in banks. The PSU banks in particular are currently burdened with non recoverable loans of proportions not seen in years. There has been little or no penalty by the RBI on banks that have failed to sustain asset quality and protect the interest of depositors and shareholders. And now the glaring instances of fraudulent practices in several banks cast a shadow on effectiveness of the central bank.

The recent instance of fraud in Bank of Baroda, reminds us of the money laundering cases in 2013, revealed by Cobrapost. Since then, the RBI has not taken any meaningful measures to avert the growing instances of fraud. In fact by the central bank's own admission, the quantum of billions lost to bank frauds has been growing each year. And bank depositors could get increasingly nervous about the safety of their deposits without adequate action by the central bank.

Impact of bank fraud menace on economy

03:45
We keep writing about the impact of Megatrends on Indian economy. And one of the signals we had emphasised on was valued added exports especially of manufactured goods. In an interview to Economic Times late last year, ex-RBI governor Dr Subbarao revealed that according to him the first signs of Megatrend will shape up in India's engineering and manufacturing revolution. He reasoned that India needs a big manufacturing sector in order to generate jobs for hundreds of millions of people. The government too has been making a lot of noise in this regard, especially with the PM's pet project - Make in India. But as you know our review of the progress of Megatrend signals in the engineering sector and with respect to Make in India are mixed.

While the plans hold promise, the execution of reforms in the areas of engineering and manufacturing has left a lot to be desired. To add to that, global economic crisis and the Chinese slowdown has dealt a heavy blow to demand for Indian engineering products. India's engineering exports to its neighbouring countries, including China, have seen a massive fall in August 2015. And this clearly signals the demand slowdown getting all the more pervasive. Engineering exports' basket that contains steel, non-ferrous metals, industrial machinery, transport equipment, aircraft parts and others have shown a big drop of 42.9% to China. Having said that it is not just India but most emerging markets that were exporting machinery to China that have got impacted. While this maybe a temporary phenomenon, without adequate reforms in the engineering and manufacturing spaces, the early signs of Megatrend have the risk of fading.

04:45
At the time of writing, the Indian markets were trading in the green. The BSE Sensex was up by about 145 points or 0.5%. Gains were seen in engineering and banking stocks, while commodity and pharma stocks were trading weak. The midcap and smallcap indices were also trading firm.

04:50
 Today's investing mantra
"Look at market fluctuations as your friend rather than your enemy; profit from folly rather than participate in it." - Warren Buffett

This edition of The 5 Minute WrapUp is authored by Tanushree Banerjee (Research Analyst) and Bhavita Nagrani (Research Analyst).

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