We keep on hearing that “ Small Cap Stocks Outperform the Market in Bull Run & Severally get whacked in Bear markets”. Contrary to this statement, I am a firm believer in the fact that Small Caps are the stepping stones of creating wealth. So, I thought of digging dipper into this.
The most obvious reason that occurred to me for the drop in small cap companies prices was low liquidity. By lower liquidity I mean lower number of shares freely traded in the market,Lower trading activity resulting in lower market participants.
Also, keep in mind that only a very selected stocks have F&O Trading available for them that excludes Small Cap companies. All these implies that Small cap Companies Share price will Fluctuate a lot with little small trading activities either way. So in a bull run the share prices soars & in a bear market the price plunges.
Also, some are of the opinion that these are dependent on Single Industry, Domestic Economy as well as they face problem in raising capital via credit facilities.
I have a different opinion to counter this point. Does Bear market mean that people are not going to use the company’s products ? There might be some slowdown but demand in a country like India is not going to go down for a long time. Problem in credit facilities can be faced by all companies in a bad market irrespective of there sizes.
Another point I will like to make is the recommendation made by Big Brokerages/Investment Banks to buy Blue Chip companies which in turn makes more and more investors buy/sell these blue chips, increasing the liquidity. There are rumours of these brokerages receiving some benefits for covering these companies.
Does this mean we avoid small stocks?
There will be corrections or even sharp drop in prices in a bad market but as soon as the market regains momentum these Small Caps are going to bounce back. Over a long term a small or mid cap stocks give a much higher return than a large cap company. These small and mid caps are the future large caps.
To validate my observation, I have some statistics from an article from Business Line. There study shows beside some outliers, small caps have been a real wealth creators. They chose 1648 companies with a Market cap of less than Rs 200cr as on April’2004 for the study. Of these 44% of companies gave a return of 1 to 10 times, 17% gave return of 10 to 100 times & 1.4% giving more than 100 times. When compared to large cap 63% stocks gave returns between 1 to 10 times and just 12% more than 10 times and most of them towards closer end of 10 times return.
But if look at the comparison between the price erosion, 22% small cap stocks have seen the prices drop in these 10 years compared to just 8% in large cap.
Eclerx, a small cap stock which was trading at Rs 448 in Dec 2007 fell down to One tenth of its price in a matter of 8 months. Did anything change in the business of Eclerx? NO
It was having a PAT margin of 30% & its was showing continuous growth. If one had bought this Mid Cap gem at the 2008 low, would have made a gain of more than 26 times in a matter of just 6 years.
So, the key to pick a Small cap is to see the Fundamentals, Corporate Governance, Low Debt levels & Size of opportunity in front of them.