Small cap stocks are not covered by analysts and one finds it difficult to gather information about them. It makes sense to invest in mid and large sized companies, due to better risk adjusted returns as compared to small and micro cap stocks.
Trade Smart Online
Investing in unknown small companies is like driving on an express highway with blinders on, we all know the end result. Picking up small-cap stocks is far riskier and a tougher job than investing in mid cap or large cap ones. There are various reasons for it. The most important one is management quality, rather than the business or sectors these companies operate in.
For an investor, investing in a bad business with good management will give a better return rather than investing in a good business with bad management. We have skeletons of numerous IT companies lying by the wayside to prove this point. The same is true for every sector. A boom in any sector attracts genuine promoters as well as those who want to make a quick buck on the stock. Differentiating them is the art part of investing. Identifying good companies on the basis of financials is the science part of investing.
How the management utilises its resources is the first give away sign of a management. Employee churn, especially of professionals at the top level gives an idea of how the management. Non-promoter professionals at key position will stick on to a company only if they find the company and its management to be genuine. Successful investors give the most weightage to quality of management.
Promoter’s stake in the company is also an important factor to note before investing in small cap stocks. In combination to promoters’ stake, it is important to note if they have any other business in similar line. There are many small cap companies where the promoters have a small stake in the listed company but have an unlisted one in a similar line of business. Needless to say which business they would be keen in growing.
Another distinguishing feature of a small cap company is the high level of debt to equity ratio. Highly leveraged companies are struggling to pay their bankers who have the first right to their money than shareholders. Investors naturally will not reward these companies.
Having said that; it is not that all small cap companies are bad. There are many companies who are still small cap for a number of reasons. Since market capitalisation is the product of equity capital and share price, a company with a small equity cap is at a disadvantage when compared to a bigger one. Small equity capital also reduces the liquidity in the stock which prevents institutional investor from entering the stock and giving it higher discounting.
Further, a good company in a bad sector will remain small cap for some time before the sector is back in favour. It would test an investor’s patience before the stock is back in limelight. But good stocks with strong fundamentals are always discovered and move up faster than the weaker ones in the sector.
Small cap stocks are neither covered by media nor do most of the analysts touch them. Under these circumstances it becomes difficult to gather information on the company. Generally most of these companies hold their AGM in some remote place or at a time when other companies have their own, in order to discourage investors from attending it. Lack of information or transparency is reason enough to stay away from such companies.
Most of the small cap companies are generally unknown in the market place. They do not have a brand and are normally in the business that does not require much value addition. Competitors might also have little information of such companies.
A company that believes in sharing its profit by way of dividend does not remain a small cap company for long. But consistency in dividend pay-out is important. There are many small cap companies who declare dividend only when the share market is buoyant in order to capitalise on the price movement.
Till an investor gains experience and is able to differentiate between a good company and a bad one independently without external advice, it is better to stay invested in known companies with strong fundamentals. Even if the returns may be lower, his capital will be protected in most of the cases.
It is said that graves of novice traders and investors are found near small cap stocks. Such unfortunate investors were ‘advised’ to invest in small cap stocks as chances of their becoming multi-baggers is higher than a stock which is say trading above Rs 1,000. Low price is what has attracted investors in all markets.
The few success stories in these stocks attract more investors to them. Only after years of losing money do people realise that it is better to invest in good large cap stocks.