A small-cap strategy

An investor with a wide exposure to small caps can beat the Nifty.

Astronomers say life exists on earth because of the Goldilocks Principle. The planet is neither too hot nor too cold; it's just the right temperature like the porridge Goldilocks ate. The investor's equivalent would be the stock, which is receiving just the right amount of attention.

While being a gross over-simplification, it is true that over-hyped stocks also tend to be inflated in price. Completely ignored stocks can continue to be ignored, and under-priced. Of course, there is subjectivity involved in judging the ‘right amount’ of attention. Are we talking substantial institutional coverage and occasional headlines? Are we talking ‘passing mentions’ in business channels or single column items in pink papers?

Any of these may qualify because investment is a subjective exercise. Some prefer to enter a stock early before it has institutional support. Others enter only when there is solid institutional coverage. Still others only enter when it's a big company and making headlines.

Quite often, the attention is a function of size. Big companies are rarely completely off the radar because media and institutional investors track them with dedication. Quarterly statements are dissected and usually, there is guidance and forward projections. Changes in management, in marketing strategy and ad budgets are also noted and debated.

Midcaps also make the news with regularity. At the least, analysts collate quarterly results and do the slicing and dicing. Small caps very rarely make the news unless something unusual happens. Some small caps never make the news beyond statutory coverage at the time of IPOs.

The low risk investor focusses on the highly-covered large caps. These are generally the least volatile segment due to the widely-disseminated information. Of course, stocks as a class are always volatile assets but there are two further safety factors available for large caps.

One is that they contain large institutional holdings and that puts a floor on price. The second safety factor is that they are liquid; there is always a chance of cutting losses. The medium risk investor focusses on mid-caps. Here too, there is usually institutional coverage. Volatility tends to be more than with large caps. But there is usually enough reserve liquidity to cut losses and enough institutional holding to put floors on prices.

Only big risk-takers touch small caps because these tend to extra volatility and carry extra risks. There is usually no institutional holding and hence, no floor. There is also a great deal of opacity and absence of information in terms of governance, marketing strategy (if any), etc.

However, given the lack of information, any coverage of a small-cap is worth noting. It usually denotes either an exceptionally favourable event or an exceptionally unfavourable one. There is a high “signal to noise” ratio because there is little noise.

Between May 2004, when the first UPA government took charge, and January 2008, there was a bull run. The Nifty, which is of course, large-caps, generated returns of around 392 per cent from trough to peak. The NSE Midcap Index registered returns of around 440 per cent and the BSE Small Caps returned 704 per cent. Between January 2008 and October 2008, the Nifty lost 65 per cent while the Midcaps lost 73 per cent and the Smallcaps 77 percent.

If we assume passive holdings between May 2004-October 2008, the Nifty was up 77 per cent (CAGR 15.5%) while the Midcaps was up 46 per cent (CAGR 10%) and the Smallcaps was up 85 per cent (CAGR 16.5%). The movements can be viewed in the light of the theory that high risk needs to be associated with higher returns. The Nifty follower risked less than the small cap dabbler but on balance, gains less. The Midcaps investor was the worst off.

However, there is another practical point. The Nifty is easily tracked and hedged, via index funds and derivatives. The Midcaps comprises 234 companies, while the Small Caps comprises 474 companies and neither is covered by index funds. Both are impossible to track for small investors.

At best, we can say is that an investor with wide coverage of small caps would have a good shot at beating the Nifty. But the excessive volatility makes it possible that there would be a large negative (or positive) tracking error in benchmarking any small caps portfolio to the Smallcaps Index. This is where some judicious filtering on the basis of the Goldilocks Principle may help.