Discovering Best Smallcaps

When Will You Start Owning Sensex 2030 Stocks?

Indian Rayon, Premier Ltd, Gujarat State Fertilizers, Hindustan Motors, Bombay Dyeing, Mukand Ltd and Century Textiles.

Do these names ring a bell? Maybe they don't. Unless you've been investing in stocks for more than two decades. Readers who have will recall that these were the Sensex's most hallowed businesses back in 1992.

In July 2016, we completed 25 years of the so-called economic liberalisation. The reforms unleashed in the '91 Budget helped break many regulatory bottlenecks for businesses.

In theory, every well-established listed company then should have been a raging stock in the decades to follow. The Sensex has become a ten-bagger between 2002 and 2016. A patient long-term investor in Sensex '92 stocks should have enjoyed similar fortunes.

Investors willing to hold few stocks for a tenure of ten years or more need to look beyond blue chips.

So, here is what they need to do - Discover the profits that lie hidden in unusual small caps.

These could be the businesses that could possibly feature in the Sensex of 2030. Reason being they will be more receptive to change.

These are small and nimble business. So, could be more adaptive to technological shifts. And with rapid growth, they could eventually acquire the scale necessary to make them big blue chips.

Why Every Investor Must Have Small Caps in Their Portfolio?

Should all investors, even those new to the stock markets, buy smallcaps at all?

We at Equitymaster, are very clear about our answer. Yes! To prove our point, we quote legendary investor, Warren Buffett:

• "It's a huge structural advantage not to have a lot of money. I think I could make you 50 percent a year on $1 million. No, I know I could. I guarantee that.
  
  The universe I can't play in has become more attractive than the universe I can play in. I have to look for elephants. It may be that the elephants are not as attractive as the mosquitoes. But that is the universe I must live in."

Think about it. Most people don't have the kind of money to invest that fund managers do. This is a good thing. It means you don't need to look for elephants. You can swat the attractive mosquitoes instead! Here's why every stock market investor should have the best quality smallcaps in their portfolio.

• High growth potential: Imagine two companies in the same industry having similar solid fundamentals. Then, in the long-term, the company which grows faster will create more wealth. A good example: Amara Raja v/s Exide.
• Valuation disconnect: Good quality smallcaps tend to significantly outperform largecaps in the long-term. But the key word is 'long-term'. Investors need to be patient with smallcaps. This is because of their lack of visibility. This can result in periods where the stocks' potential is not realised quickly. But when it is realised, the returns are huge. You can use this period of valuation disconnect to slowly accumulate such stocks.
• Lack of institutional ownership: Remember Buffett's words? Institutional investors are busy hunting elephants. This is great news for the aam investor. If you can get in early, before the big guys, then big gains await you!
• Liquidity: Many smallcaps are not heavily traded. This presents a good opportunity. A good quality smallcap, which is growing earnings over time, will attract attention. As the public becomes aware, demand for the stock goes up. When this happens, many investors bid for a limited number of shares on offer. The result? You guessed it! The stock price rises rapidly.

If you believe that high quality smallcaps belong in your portfolio, then the next logical question is how do you find them? Smallcaps are risker than largecaps. How to mitigate the risks? How much exposure should you take in each small cap? We do this for a living. And I can assure you, the process is not easy.

Discovering smallcap stocks...

It is quite an ambitious target to beat the long-term track record of a legendary investor like Mr Warren Buffett. However, it's quite doable. This is because you have certain edge over Mr Buffett and big fund managers. It's something that Mr Buffett himself acknowledges:

"If I was running $1 million today, or $10 million for that matter, I'd be fully invested. ... It's a huge structural advantage not to have a lot of money."

As small investors, you have the privilege to move beyond the over researched universe that most of the big investors are confined to... And hence beat some of the best investors.

However, small cap is an under researched space. Because of a lack of unbiased and independent research, many investors have burnt their fingers. We realized that with a sound investing process, the small cap space offered investors the potential for multibagger returns.

It was this 'big picture' idea behind starting Hidden Treasure in 2008, dedicated to picking stocks in the small cap universe. With a strong process in place that includes meeting managements, Hidden Treasure has beaten benchmark indices nearly three times (since inception until December 2016).

During this journey, one thing became crystal clear to us. You could invest in the known bluechips and earn better returns than most other investment assets. But if you want to transform your fortunes and build serious wealth, the key is finding the right small companies that have the potential to grow multi-fold.