Rewards and risks

Picking small stocks is always difficult

The stock market has held its ground through the past several months and it is trading at all-time (closing) highs on a combination of relief and optimism. Relief because the Reserve Bank of India and the US Federal Reserve have both hit “pause” after carrying out a sequence of rate hikes. Optimism because there is a consensus that the Indian economy will grow strongly this year. Besides, China’s central bank has eased its monetary policy by cutting rates and pumping liquidity into the world’s industrial engine in a massive stimulus effort. The market has been backed quite emphatically by foreign portfolio investors, who have bought close to a net Rs. 80,000 crore worth of equity in the current financial year. Local institutions have been less bullish, with domestic institutions (other than mutual funds) pumping in a net Rs. 4,800 crore, while the equity mutual funds bought only Rs. 1,900 crore worth of stocks despite net inflows of Rs. 9,700 crore into equity schemes. Nevertheless, it may be noted that all three segments of the institutional market have been bullish and the inflows into mutual funds indicate that households remain committed.

Direct retail investors also remain bullish. This may be inferred from the fact that the small-cap indices of the National Stock Exchange and the BSE (which have different constituents) have both recorded new highs in the recent past. This segment of the market is traded mainly by retail investors since the market cap of most of these companies is too low to be held by mutual funds or other institutions. Small caps have the highest risk-reward profiles in the listed equity space. That is, they can give extremely high returns. Part of this is simply due to base effects. It is possible for a small business to double or even triple profits, market shares, and revenues for several years in a row. This is simply impossible for a large company. But it is also true that small businesses are more vulnerable to downturns — they lack the resources to ride out a sustained cyclical downturn, which a larger company with more reserves may survive. Hence, small stocks can be multi-baggers but the share prices can also evaporate. Drawdowns of 60 per cent or more are not uncommon.

In addition, there can often be issues with liquidity — trading can simply cease because there are no buyers in a downturn. Also, due to the lack of institutional research into small stocks, it is often hard to understand how a small business works. This means the likelihood of sudden bad news, or of price manipulation, or even outright fraud is also significantly higher in a small stock. Smart investors who understand these risks and are confident about doing their own research can make extraordinary returns by investing in small stocks. But they have to brace themselves for deep downturns and big losses. Most retail investors lack these skills — they tend to follow the trend or get drawn into “pump and dump” schemes.

The Indian economy is likely to remain the fastest-growing large economy and that would attract portfolio investment. However, small investors would do well not to get carried away with rising stocks, particularly in the small-cap space. A sharp run-up could result in equally sharp pullbacks in the small-cap space. Ill-informed stock selection at the peak can be damaging for the portfolio.