Small caps: Upsides come with higher risk

Smaller stocks gain more than big stocks during bull runs and lose more than big stocks during bear markets. There are several possible explanations and my guess is, they are all partially true.

The simplest reason is relative size. Share price appreciation is linked to percentage earnings growth. A small company may grow faster just due to the base effect.

But a small company is also more vulnerable. It has fewer resources – less money, smaller teams and often, narrower client base. Since less attention is also focussed on smaller companies, corporate governance issues can also surface without any warning and these things are prone to happen in bear markets.

Beyond this, there are technical details for exaggerated movements in smaller companies. Smaller companies have fewer institutional shareholders. The shareholder base lacks deep pockets and patience. Small companies also have less liquidity since free float and overall equity is by definition, low.

This can have positive effects. In a bull run, demand for shares outstrips supply by big margins.

Less liquidity also means that volumes dwindle in downtrends. This makes it tough to unload large positions and in turn, this can cause panic.

Another factor comes into play in Indian markets. There is no shorting mechanism for a small company. Stock futures are not available and the Indian stock-lending mechanism is, in effect, impossibly cumbersome. At best, there may be day-trading shorts created. But such positions must be covered inside the session.

The absence of a shorting mechanism doesn’t eliminate downtrends or uptrends; it makes trends in either direction steeper because one mechanism for a counter-trend is removed. Even after several consecutive lower-circuits, short-covering cannot come in to offer support. Equally true, if there are several consecutive upper-circuits, there is no resistance created by a build-up of shorts.

One simple way to verify this is to examine stocks which have been removed or added to the stock futures segment. Volatility tends to increase and trends in either direction get stronger when stocks are pulled out of the derivatives segment. When stocks are added to the futures segment, volatility plateaus or actually drops.

In a bear market, mid-caps and small-caps become more dangerous holdings. Even if you are certain about the fundamentals of a mid-cap, or a small- cap, you need to be cautious about buying during a downturn because prices can just continue falling.

One necessity is checking delivery to volume ratios carefully to gauge the levels of actual interest versus the apparent liquidity before you buy a smaller stock. Another trick is to try and judge your own pain levels. Will you stay in the stock, if say, two consecutive lower-circuits are hit? These are questions the individual investor needs to answer. It takes less money to invest in small-caps but the risk levels can be much more.