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Use this Rule when Buying Smallcaps

Nov 14, 2023

Use this 4% Rule to Avert High Risk Smallcaps

The very nature of stocks that create the biggest wealth is that they are rarest of the rare.

If you do not believe me, consider this statistic shared by Gautam Baid, author of Joys of Compounding and earlier a guest on Equitymaster Investor Hour.

Between 1926 and 2018, in the US stock market, only 4% of all listed equities accounted for 100% of the wealth creation.

You read that right.

In as many as 92 years, only 4% of all listed equities in the US accounted for all the wealth created there.

Now since we are referring to the American stock markets, we cannot blame the underperformance of 96% stocks on the lack of maturity of the markets. Nor can we attribute any economic or geopolitical risk as the cause. This is because the performance has been gauged over nearly a century.

Does this apply to Indian stock markets too?

It certainly does!

Simple as it may sound, selecting the 4% of the listed stocks and holding on to them for decades requires skill, determination, patience and grit.

Unfortunately, most investors who enthusiastically start out in the stock markets withdraw or get dismissed too soon. Few others manage to go some way, but their stocks keep failing in wealth creation.

Just a handful of investors manage to get to the finish line of their long investing horizon to see their stocks compound into true wealth.

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My favourite advice here is: To finish first, you must first finish.

In fact, I often cite the similarity between the marble and spoon race and stock markets.

In the marble and spoon race, most participants underestimate the importance of posture, concentration and goal setting. As a result, barely anyone reaches the finish line.

The usual traits of speed, strength and agility, necessary in other races, do not serve well here.

Turns out the biggest wealth creators in the stock markets are businesses that have thrived for decades. So, it is not surprising that in the US they were just 4% of all the listed businesses, over a century.

Investing in them requires the skill that does not apply to 96% of the other listed stocks.

The other 96% stocks may comprise of bluechips and midcaps of ordinary quality. Or smallcap and penny stocks offering temporary value upside.

Now there is a good chance that some of these stocks fetch decent returns over few months or few years.

So, I am not ruling out buying few smallcaps and penny stocks, after necessary due diligence and with some safety in valuations.

By all means, these stocks comprising 96% of the market, when selected diligently, may be good for near to medium term gains.

If you're lucky, a few may even turn out to be multibaggers. But given the low allocation to such stocks they are unlikely to move the needle of gains in your portfolio.

But focussing your time and energy to pick the venerable 4% stocks and holding them for the longest investing tenure will make a difference.

Paying any attention to the chaos around or turning to see other participants can be the biggest risk in the marble and spoon race. Similarly, too much focus on other investors or volatility in the market, can never be the recipe for stock market fortunes.

Now, if you are worried of an impending market crash hurting your dreams of creating stock market fortunes, you aren't alone.

What if I tell you the 4% strategy is not only perfectly positioned to survive a market crash but it also stands to gain immensely from a market crash...

In the stock markets, the fortune of the benchmark indices has come to rest of few star performers over the years. The bulk of the investor money comes to them.

And investors firmly believe that only these stocks could create wealth over the long term.

But the fact is the performance of index stocks will, at best, trail the index over the long term.

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So, if you are looking to make big gains in bluechips over the next decade, then you need to look beyond the Sensex stocks

You see, a lot of the quality bluechips are not just restricted to the Sensex alone.

If you widen your horizon a bit and look at let's say, the BSE 200 index, then there are quite a few bluechip stocks that are set to deliver handsome gains over the long term.

The easiest way to track what could help stocks have a long runway of superlative returns is to find qualities that can help them overcome every crisis.

For instance...

1. Capital efficiency

The companies that prioritise reinvesting profits to earn higher returns on their shareholders' equity rarely go wrong in capital allocation.

Such companies are careful with capex and acquisitions. Plus, surplus cash is often distributed to shareholders. The idea is the more profitable the company gets, the more value it will create.

2. Low leverage

Minimal debt (debt to equity ratio) is extremely important for companies to tide over periods of tight liquidity and high interest rates.

3. Profitability with low capex

Companies that have already done the hard work of building plant and machinery or network for future growth, are typically in a ripe phase to benefit from their efforts.

4. Scope for PE expansion

Ironic as it may sound, even some of the most solid businesses with reasonably high PE multiples tend to have a huge room for PE expansion, over very long term, if the business and management went in the right direction.

If I must pick just one characteristic that has been the key catalyst of several decadal multibagger stocks in India like Asian Paints and Titan, it would be their PE expansion. Larger the PE expansion higher has been the quantum of returns for the top multibaggers.

5. Last but not the least...Technology Catalyst

Technology has the power to change lives over time.

Imagine a world in the future where an autonomous vehicle picks you up for work. It plays your favourite playlist. And it makes a quick stop for your morning coffee.

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All this, without you having to reach your wallet or your phone. This is how devices enabled with Internet of Things (IoT), could transform our everyday lives.

The reason this technology is so important is because it could transform the future growth rates of multiple business. When I say that I mean businesses as diverse as healthcare, automobiles, financial services, retail and agriculture.

Now, as an investor looking for exponential profits over next few decades, you cannot just look for tried and tested businesses. Or the most popular brands.

Rather you need to need to look for stocks where technology is acting is a huge catalyst of change that could offer exponential earnings growth in the years to come.

So, even in India, just 4% of listed stocks can be the true gamechangers for an investor's portfolio.

Having the patience, perseverance and discipline to find and hold on to them can offer the compounding effect that 96% of the stocks can't.

Warm regards,

Tanushree Banerjee
Tanushree Banerjee
Editor, StockSelect
Equitymaster Agora Research Private Limited (Research Analyst)

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1 Responses to "Use this Rule when Buying Smallcaps"

ASHU chopra

Nov 15, 2023

Great

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Equitymaster requests your view! Post a comment on "Use this Rule when Buying Smallcaps". Click here!