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The Equitymaster Research Digest

The Success Formula for Small-Cap Investing (Hint: It's Not Just about Spotting Multibaggers)
Apr 26, 2017

  • Dealing with stock price corrections - volatility vs risk
  • Revealing smart money secrets
  • False alerts vs rats

    All men's miseries derive from not being able to sit in a quiet room alone. - Blaise Pascal

My team recently attended a lecture on 'what happens when you buy a stock'.

Most value investors would answer that question with 'be still'.

Easier said than done, though. Especially in a falling market.

For example, what happens when you buy a stock...and it corrects, say, 30% in less than two months?

Volatility or Risk?

Would you have the conviction to keep holding? Or buy more?

This isn't some hypothetical example.

It's a recommendation the Hidden Treasure team made in mid July 2015: Ambika Cotton at Rs 1,052. By 15 September, the stock price had crashed to Rs 721 - a fall of 31%.

We got a lot of queries from subscribers. Some asked why we don't have stoplosses. Some told us they wanted to sell. Others asked if the Buy view was still valid.

As always, we'd met the management before we recommended the stock. The textile business is commodity-like and known for poor returns. But Ambika Cotton had carved out a moat for itself in a niche sub-market within the industry. The company alsohad impressive financials.

We were mightily impressed with the integrity and competence with which Mr Chandran (the promoter) runs the business. His simplicity and aversion to useless expenditures was a huge plus point.

While we did not know why the stock had corrected, we were still confident about the fundamentals, so we maintained our Buy view, recommending subscribers to add as long as their exposure was within the suggested asset allocation limits.

Our discipline paid off.

As you can see in the chart below, the stock has rewarded those who had the patience and conviction to hold during the crash and following period of volatility.

Ambika Cotton - An Adventurous Journey

I bring this up today because another fundamentally strong recommendation of ours is in correction phase.

We recommended it in March 2015. A subscriber recently wrote to me saying that he had exited his position. His reason? The stock corrected after our recommendation and stayed low for a long time.

Incidentally, the stock was up 16% the day after the subscriber sold out. We still have a Buy view on this company.

My point is that, for small-cap stocks, prices are likely to be volatile and may lag behind fundamentals in the short term. You may be tempted to hit the panic button many times, but to make money in this space consistently, it is crucial to know when not to press the button.

Hidden Treasure's 33% CAGR returns since inception versus 12% from the benchmark index is not just a function of spotting multibaggers...

It's about developing the conviction and temperament to hold them. And I can't emphasise enough the importance of in-depth research and management meets to have that conviction and patience for that.

False Alerts vs Smelling the Rats

Mind you, I am not suggesting you buy a stock and forget it for five years. No matter your research and conviction, things may turn out differently. Too much attachment to the original thesis, despite facts suggesting a deterioration of fundamentals, can lead to bias...and eventually losses.

It reminds me of MT Educare.

A strong franchise, delinking of the business with star teachers, an all-encompassing coaching menu, asset light business, zero debt, negative working capital, over 40% payout ratios, return ratios in the range of 20%...

MT Educare, at the time of recommendation, had all the ingredients of a successful and stable growth story in the education sector.

However, after one last meet with the management, we realised they'd changed their strategy. In the pursuit of growth and market penetration, they chose to play with fire. The company resorted to strategies that did not bode well for margins. Most critically, they decided to borrow Rs 80-100 crore, turning the company from debt-free to a debt-to-equity ratio of 0.7 times.

We didn't believe the new strategy would earn good returns. So we recommended subscribers to Sell MT Educare (with no losses and no gains).

We were quick enough to sense the change in fundamentals and flexible enough to question our own thesis. MT Educare did not help our track record. But with a timely exit, we avoided losses as high as 39%.

MT EducareStock Price Movement Post Sell View

Discovering Smart Money Secrets

As you may know by now, Rohan and Kunal have been working on a project to track the smartest minds in value investing.

They call them 'superinvestors'. Over the last few weeks, the guys published a series of interviews with Indian superinvestors. And now, they have compiled them all into a special report called The Superinvestors of India.

Click here for get a free copy.

Now, because of insights from these interactions, Rohan and Kunal have their eyes glued on insider activity and bulk and block deals...

But what is the end game of this 'superinvestor project'?

As per Kunal...

The guys will reveal these secrets soon. Stay tuned.

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