Small is beautiful… but can be risky too

Small- and mid-cap stocks, believed to be multi-baggers in the making, come bundled with higher risks.

S. Hamsini Amritha

Be it the world of cars or the stock market, “small” appears to be in vogue. In the equity rally that began early March this year, stocks in the mid- and small-cap space have delivered returns that trounce those of their large-cap competitors.

Wondering what makes these stocks so attractive? Well, it is their high-risk and high-return positioning that charms the most, though their low valuation also appeals to certain investors. Read on to understand why small- and mid-cap stocks, believed to be multi-baggers in the making, come bundled with higher risks.

Market capitalisation, an indicator of the value placed on a company by the market at that day’s price, is a product of its market price and outstanding number of shares.

While there’s no clear-cut demarcation to differentiate the stocks based on their market capitalisation, given the dynamism of the equity markets, it can be assumed that stocks with market cap less than Rs 2,000 crore fall in the small-cap category, while those above Rs 7,500 crore are of the large-cap genre. The ones that fall in the middle zone are the mid-caps.

Large caps – few surprises

Large-cap stocks enjoy a large scale of operations; have established business model and hence have lower uncertainty in business. Besides, analysts, fund managers and investors alike, closely monitor these stocks. So, while the risks associated with investing in large-cap stocks are known, their likely returns aren’t unknown either.

This makes large-cap investing safer and more suitable for investors who have little stomach to relish uncertainties in investing. This is also why large-cap stocks are most sought after during periods of uncertainty in the markets. But on the other hand, investing in small and mid-cap stocks comes with higher risks, given their lower scales of operation.

While some of the companies in this cadre are still far from establishing their businesses, others are relatively new in their sector — which makes predicting their future revenues tougher. But it is precisely this heightened business risk that sweetens their return potential significantly.

History has it that multi-baggers in most equity rallies are, more often than not, stocks from the mid- and small-cap category only. It is then no surprise that the current rally too saw the small- and mid-cap stocks return higher.

When benchmarked on their year-to-date returns, the mid- and small cap stocks have scored a stellar 80 per cent and 85 per cent returns, while the BSE Sensex gained by 60 per cent.

High risk, high return

The desire to invest in smaller companies comes, from their ability to return higher. Sidelined by analysts and investors and weighed down by the higher degree of earnings risk, these stocks do not command the valuations that larger companies usually do in the stock markets.

For instance, while a large diversified company such as L&T commands a consolidated valuation of about 25 times currently, smaller ones such as McNally Bharat or Shriram EPC, which are in similar lines of business, enjoy a lower value. Why? While L&T has a wider business presence, large clientele and stable earnings outlook, the smaller ones compare less favourably with it on almost all these counts.

However, with the economy beginning to revive and credit availability easing up, investing in smaller companies may hold higher returns potential, with the advantage of a low base.

Not only do these companies hold the potential to grow at a higher pace; their earnings growth cannot also be easily replicated by their large cap peers either.

For instance, while net profits of Yes Bank have grown at a compounded rate of 53 per cent over the last three years, that of ICICI Bank has grown at about 10 per cent only.

It is this ability to scale high earnings growth that fuelled the recent rally in the mid- and small-cap space, once it became clear that the economy was beginning to get back into shape. For instance, between the cement major ACC and its smaller peers Dalmia Cements and Shree Cements, the stock performance of the latter two was way better in the run-up since January. While ACC delivered 68 per cent returns, the other two stocks registered 82 per cent and 131 per cent returns, respectively.

The trend was similar among stocks in other sectors such as FMCG and IT too. Infosys’ 38 per cent return since January appeared trifle when compared with the triple-digit gains recorded by mid-caps MindTree (117 per cent) and Hexaware (149 per cent).

Earnings trap

But if investing in small- and mid-cap stocks appears exciting, don’t turn a blind eye towards their earnings. While it is natural to get carried away by the seemingly low valuations, remember that they do so for a reason.

If the probability of these stocks to more than double their earnings is high, the probability of their non-performance is also equally high. Since their businesses are at a nascent stage, their earnings are highly vulnerable to a downturn. In 2008, a year mired with recessionary trends, the BSE Sensex declined by 53 per cent. But the mid-cap and the small-cap indices declined more, by over 67 per cent and 72 per cent, respectively.

This may explain why ACC trades at 13 times, while Dalmia Cements or Shree Cements trades lower at eight times and seven times. Here again, while the mid-caps are somewhat better off, it is their still smaller peers that become unpredictable during uncertain times.

Besides earnings risk, investing in small-cap stocks also bundles with it liquidity risk and higher impact costs. And since most small stocks sport a high promoter holding, the promoters’ credibility also becomes pivotal in determining the fate of your investments.