Less leverage, quality management; better bet than large-cap shares?
No doubt the large-cap stocks offer a better risk-reward for the retail investors, but the precise selection and right portfolio mix of mid/small-cap stocks can generate alpha and wealth over longer term
By Arun Malhotra
Investing in small caps is a dilemma. Investing in small and mid-caps has been manifested with a lot of complexity, information uncertainty and issues of liquidity and impact costs. We believe mid and small-cap stocks display cyclical nature, unlike the large caps that are steadier. Mid and small caps typically have short boom and burst cycles – they are cyclical in nature and best returns can be harvested if you play the cycle right. We have seen enough disruptions – on the macro front, political or geopolitical, and even frequent change in regulations, and these small size companies are more prone to risk under these uncertain environments. The fundamentals of mid and small-cap can change quickly under these circumstances and the prices can fall quickly. Mid and small-cap investing works best when picked from the bottom of a bear market.
Investors look for undiscovered stocks, basically for potential multibagger gains. There definitely exists an opportunity in this space, as these stocks are under-researched and hence under-priced also. But the characteristics of a good quality business that we look for – the fundamental reasons why we own stocks (businesses) is true for mid and small caps too. Management quality is the single most important factor, more so in this case, as lesser information and limited performance track record of the company and owners are available in the public domain. On the other hand, large caps deliver steady returns with relatively lower risk. We will find lots of large caps, even in Nifty 50 or top 100 stocks that have been a long-term compounder of wealth. Stocks like HDFC twins, Kotak Mahindra Bank, Infosys, and Reliance Industries Ltd (RIL), etc. have been a no-brainer and have generated significant wealth for their stakeholders. These comfort stocks, unlike the mid and small-cap, have less volatility and hence better risk-adjusted returns.
There exists an information and survivor bias whenever we talk of mid and small caps, as only the surviving mid-caps and their multi bagger returns are talked about, while there are a lot of companies in the mid and small-cap space that have gone burst and fallen off the radar or closed their businesses. There lies the need for a knowledgeable investor, the right advisor, the fund manager who can balance the portfolio risk effectively and include the large and Mid/small caps in the portfolio to generate excess returns. Best returns are reaped when you catch midcap and it transforms into a large-cap in few years and there exist so many examples around us. Stocks like Eicher Motors, Page Industries, AIA Engineering, Shree Cement, and Astral pipes fall in that category and have weathered various storms (economic disruptions) and emerged successfully, and in the process created tremendous wealth for their stakeholders. And these small/mid-cap stocks that generated excess returns over long periods of time had similar characteristics- less leverage, huge market opportunity, capable and quality management, focus on productivity and capital efficiency and concern for their minority shareholders.
No doubt the large-cap stocks offer a better risk-reward for the retail investors, but the precise selection and right portfolio mix of mid/small-cap stocks can generate alpha and wealth over longer term. The portfolio composition becomes important and depending upon the risk appetite of an individual, the right proportion of large-cap stocks and Mid/small-cap stocks should be included in the portfolio. I am confident that such a portfolio can generate returns that far exceed the benchmarks over longer periods of time. The debate of large-cap vs Mid/small-cap will keep on, the research on this has been going on for ages, but there is no denying the fact that small and mid-caps deserve a risk premium over large ones. Both the categories are important for generating excess returns in a portfolio.