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The Equitymaster Research Digest

Just 14% of All Small Caps Offer Massive Opportunity
Mar 28, 2017

  • The problem with the small-cap index
  • More cockroaches in the kitchen after Amtek Auto and Satin Creditcare
  • A fund manager who hit the bull's eye on smallcaps

Small-caps stocks have essentially two characteristics: They are easy to buy, and they are easy to lose money on.

Subscribers often ask us why we recommend barely a handful of the index's 750-plus small-cap stocks. We especially hear it when index valuations appear cheap.

The thing with the small-cap index is it doesn't even remotely reflect the opportunities in individual companies. You cannot do a bigger disservice to yourself than buying and selling small caps based on the valuations of the small-cap index.

The BSE Small-Cap Index gained 14.7% in the past twelve months. The valuations of the index (at 62.5 times PE) are currently at lifetime highs.

The database tells us that about two dozen small caps gained more than 200% in the past year. That is about 2.5% of the stocks in the index. And about 108 stocks doubled in the past year. That is about 14% of the small caps in the index.

Now, one year is too short a time frame to measure the true return potential from small caps. More often than not, these quick gains are backed by speculation and aren't sustainable. We typically recommend to buy small caps with at least a three to five-year perspective.

But having said that, the proportion of solid small caps with massive fundamental upside is about 14-15% of the index. Zeroing-in on them requires skill in valuing the businesses, experience in judging small-cap managements, and the guts to say 'no' 85% of the time.

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